Aviva Investors Canada Inc. Fixed Income Quarterly Commentary – June 2019
GLOBAL ECONOMIC REVIEW AND OUTLOOK
Economic Review Q2
The global economic outlook deteriorated during the period. Industrial production data and manufacturing surveys were generally quite weak, which appeared to be at least partly attributable to the ongoing trade dispute between the US and China. This is having an adverse influence on trade volumes globally, in turn affecting demand for manufactured goods.
With inflation under control, global central banks are responding to deteriorating economic indicators by downgrading their forward guidance for interest rates or, in some cases, starting to ease policy settings. In the US, for example, it became increasingly likely that borrowing costs will be lowered. By the end of June, markets had priced in an 85% probability that the Federal Reserve would lower US interest rates during July. Thankfully, central banks in the US, UK and Australia do have some available firepower to try and spur growth – with positive interest rates, officials are able to ease policy settings. This process began in Australia during the quarter, with borrowing costs being lowered for the first time in nearly three years.
In Europe, comments from the European Central Bank president suggested officials were considering ways to underpin activity levels following a slowdown in several countries in the region. Unfortunately, conventional monetary policy levers have been largely ineffective in the Eurozone – even with zero official interest rates, economic growth and inflation remain well below target. As a result, further quantitative easing measures are rumoured to be on the agenda. Japanese policy makers face a similar challenge, with existing efforts to revive the economy proving unsuccessful.
Market Review Q2
Equity markets continued to fare well in the June quarter, following on from favourable performance in the March quarter and extending gains in the year to date. The MSCI World Index returned 4.2% in US dollar terms, with Europe ex-UK being the strongest region at around 6%. Evolving interest rate expectations provided a strong tailwind. It is felt that the prospect of more accommodative policy settings will support growth and, in turn, corporate profitability.
There were also hopes that progress was being made between the US and China in their ongoing trade conflict. While no concrete agreements were made, US President Trump announced he was delaying the introduction of proposed additional tariffs on goods imported from China after meeting the Chinese President as part of the G20 summit. Investors took this as an encouraging signal that a truce remained possible, alleviating the risk of a more prolonged and damaging ‘trade war’. This development supported share markets in Asia and other emerging regions.
Bond markets also generated positive returns, reflecting a substantial move lower in yields. Generally subdued economic indicators and persistent geopolitical risks saw bond yields fall and supported returns from fixed income securities globally. By the end of the period, US Treasury yields had fallen to their lowest levels in around two and a half years and those in Europe had dipped to record lows. At the end of June 10-year government bond yields in Europe and Japan were negative, underlining the challenges facing policy makers.
Like equities, corporate bonds were buoyed by the prospect of more accommodative policy settings. Lower borrowing costs should make it easier for corporate borrowers to service their debt repayment obligations and should help ensure default rates remain low. Corporate earnings are also holding up well overall, further supporting sentiment towards credit markets.
While headline growth in the US and Europe has been quite resilient, the global manufacturing and trade outlook has worsened as US and Chinese officials have been unable to resolve their trade dispute. Accordingly, our global growth forecasts have been revised lower for both 2019 and 2020. Encouragingly, at this stage it appears likely that a combination of looser monetary and fiscal policy will be sufficient to avert a serious downturn.
Inflationary pressures remain muted in most major regions. Combined with tepid growth, this has resulted in a marked change in the outlook for monetary policy globally. In the US, the Federal Reserve has indicated that interest rates are likely to be lowered this year. Markets have priced in more than 100 bps of rate cuts in the year ahead. We do not expect such significant moves, but it does appear likely that US rates will be cut in the months ahead.
Evolving expectations for monetary policy in the US and elsewhere supported valuations of risk asset in the first half of 2019. In the past six months, equity and credit markets have enjoyed positive returns. Given the strength of the rally in global equities, and with valuations close to long-run averages, the scope for a further meaningful move higher seems limited, even with policy support.
Performance summary: Outperformed the index by 16bp for the second quarter, bringing year-to-date performance to +35bp versus the index.
Contributors: Security selection was the main driver of performance, particularly within the Infrastructure, Communications, Autos and US Maple Banks corporate sectors. Broadly speaking, exposure to corporate bonds – especially US dollar and Maples – augmented performance as corporate bond spreads tightened on account of expectations of a more accommodative monetary policy stance from central banks across the globe.
Detractors: Sector allocation had a modest impact on performance, however our underweight position in provincials – a risk-reducing position – detracted from performance and limited the amount of upside the portfolio experienced from tightening credit spreads. Additionally, exposure to some US dollar investment grade bonds (Energy Transfer Partners and CVS) and one US dollar high yield bond (Genesis Energy LP) also hurt performance.
Outlook/positioning: Credit risk positioning in the portfolio has remained fairly stable over the quarter, but we have meaningfully changed the composition of this risk. Specifically, we reduced our allocation to longer-dated exposures and simultaneously increased our shorter-dated exposures where there is a better risk-reward balance. The portfolio also continues to own select $US IG and HY positions that can impart added volatility and our portfolio construction efforts aim to dampen this somewhat.
Canadian credit spreads came in during the second quarter of 2019, supported by strong demand for spread product. In fact, given various weak economic indicators during the quarter, credit markets reacted positively as the probability of monetary stimulus by major central banks has arguably increased. Canadian bond market technicals remained fairly supportive as investors continued to have appetite for provincial and corporate issuance given falling government yields and lower-than-expected issuance. Government of Canada bonds also remain well supported given falling yields inspired by a number of factors including a less hawkish view for monetary policy by both the Bank of Canada and the Federal Reserve. For the quarter, the portfolio outperformed the index, gross of fees, by 16bp primarily a function of security selection.
In the second quarter of 2019, security selection was the main driver of performance and only modestly offset by sector allocation. With regards to security selection, our US IG positions contributed 2bp of performance, particularly HCA, while our high yield positions detracted 2bp, mostly due to our Genesis exposure. The balance of our added value came from our Canadian dollar exposure, predominantly Morgan Stanley, Transurban, BCE, Ford and Capital power.
While sector allocation was modestly negative, the underlying dynamics are relevant. Specifically, our overweight to corporate bonds contributed positively to performance but was entirely offset by our underweight position to government credit, primarily provincial bonds. This underweight position is designed to help reduce portfolio risk and capture some upside benefit as corporates have a little more room to rally relative to provincials in the current environment.
Since the end of the quarter, credit risk position has remained stable. However, our spread duration contribution exposure to corporate and provincial credit has increased but when volatility of this exposure is factored in, the risk has remained fairly the same. Furthermore, our corporate positioning has moved substantially out of the 10-year KRD point to the 5-year point, where we believe the risk reward balance is substantially more favourable. We’ve also been reducing our long corporate underweight by buying longer-dated, high quality utilities as their basis to long-dated provincial paper is beginning to look attractive.
The risk positioning of the portfolio has been facilitated by an ongoing underweight in provincial paper across the curve. While provincial spreads have substantially lower volatility than corporate bonds, we believe they are, at current valuations, a particularly inefficient allocation to credit as we move further out the curve given (1) the very small amount of incremental credit spread pickup for added term and (2) other fundamental and technical factors related to considerations respecting provincial budgetary finances and
vulnerability to a plausible Canadian macroeconomic downside scenario. With respect to portfolio composition, we are overweight Canadian banks for carry and roll down but with a shorter than index duration and predominantly in legacy deposit notes. We take a more cautious approach on bail-in and NVCC as their valuations do not adequately reflect the potential for substantially more issuance amidst a backdrop of a highly leveraged Canadian consumer and greater fiscal restraint being sought in the provincial credit space (and ultimate implications for bank asset quality). Our other key overweights remain in US financials, select pipeline exposures, utilities and very short dated US autos. Given the poor diversity of the Canadian market, we also remain invested in a few key convicted US dollar investment grade issues such as Energy Transfer Partners and Cigna. Our high yield exposure is currently rather modest – just over 2.5%. We are cognizant that these allocations come at a cost of somewhat-elevated volatility and susceptibility to risk-on, risk-off swings motivated by global macro market sentiments – especially as the Canadian credit market exhibits substantially less volatility than the US. Notwithstanding this cost of ‘importing’ idiosyncratic opportunities from other markets, our portfolio construction efforts are aimed at dampening such volatility, being less reliant on spread directionality and rather focusing on efficiently allocating risk across sectors and term buckets.
We believe that credit markets are on the tighter end of the spectrum reflecting strong appetite for credit – especially as government yields have renewed their path lower. As such, we are positioned slightly more conservatively until such time that valuations warrant an escalation in the overall risk profile of the portfolio. Nevertheless, fundamentals in the market remain sound for now, even in select BBB/BB names, warranting an overweight in such sectors and names where convicted. The risks associated with Canadian financials and provincials, while highly contained for now, remain an area of close focus for us. Accordingly, we expect to benefit from our conservative positioning in these sectors over time while maintaining higher exposures in other sectors and idiosyncratic non-Canadian names.
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