Aviva Investors Canada Inc. Fixed Income Quarterly Commentary – June 2017
GLOBAL ECONOMIC REVIEW AND OUTLOOK
Economic Review Q3
The synchronized pick-up in global growth that began in 2016 continued in the third quarter of 2017. This has come from a modest acceleration in the major developed economies, with the United States, Eurozone and Japan now all growing faster than forecasts. While spare capacity has largely been eliminated in the US, monetary policy remains accommodative and growth therefore remains supported. In the Eurozone and Japan the recovery is less advanced and monetary policy remains highly accommodative. Amongst the emerging market economies, Chinese growth has stabilized after picking up in late 2016, supported by expansionary fiscal policy and continued rapid credit growth. That has supported growth in Asia and other regions that have China as a major export destination. The most notable improvement among emerging market economies, however, has been in Brazil, which has finally emerged from a deep recession. A combination of economic and market-based indicators suggest that global growth is likely to be sustained around current rates over the coming months.
With stronger global growth and the steady erosion of spare capacity, inflation pressures are expected to rise modestly. While there has been some recent softening in those headline measures, particularly in the US, that is expected to be transitory.
Market Review Q3
The improvement in global growth, alongside modest inflation, has been accompanied by a marked decline in market volatility across a range of asset classes. Low market volatility has often been associated with low economic volatility and smaller-than-usual economic surprises. In the aftermath of the volatility that came with the financial crisis of 2008, central bank asset purchases also acted to suppress market volatility, with major risk events causing only a brief disturbance in financial markets, followed by a return to calm.
Global equities rose in the third quarter as optimism towards growth in most of the major economies offset worries about escalating tensions between North Korea and its neighbors. The MSCI World Index traded 4.06% higher in local terms, which translated into a 4.96% gain for US-dollar investors. The strongest dollar-denominated performance was posted by the emerging markets (MSCI EM Emerging Markets Index +7.92%) and Europe ex-UK (MSCI Europe Ex-UK Index +6.99%).1 Emerging markets have continued to enjoy attractive returns as global trading conditions have improved. In Europe, there was further evidence of strong economic recovery, although the region’s equity markets suffered bouts of weakness as inflation data surprised on the downside. Weaker-than-expected inflation was also a feature of the US economy, despite clear signs of growth momentum returning after a poor first quarter. The S&P 500 Index returned 4.48% in US dollars. Sentiment towards the UK economy strengthened as the quarter progressed as consumer spending held up well in the face of weak wage growth and rising inflation. The FTSE All-Share Index rose by 5.50% in US dollars.1
Our economic outlook is one of broad-based, above-trend growth. We have modestly upgraded our expectations for global growth to 3.5-3.75% for 2017 and 2018. Stronger global growth will further erode spare capacity, leading to a modest rise in inflation pressures. We expect US inflation to head back to around 2% by mid-2018, but its return will be more gradual in the Eurozone and Japan. Chinese growth has stabilized after picking up in late 2016, supported by expansionary fiscal policy and continued rapid credit growth. That has supported growth in Asia and other regions that have China as a major export destination. The most notable improvement among emerging market economies, however, has been in Brazil which has finally emerged from a deep recession.
Overall, our global macro outlook leads us to prefer equities to bonds. We continue to think that our central scenario is also favorable to emerging market assets. Within the equity universe, we are selective, in particular being cognizant of valuations. We prefer being underweight US equities, instead favouring Eurozone and emerging market equities, which will benefit disproportionately from the improvement in world trade.
1 Source: RIMES as of September 30, 2017
In the third quarter of 2017 the FTSE TMX Canada Universe Bond Index generated a return of negative 1.84%.2 The negative return was driven by higher rates due to a steady stream of positive Canadian economic data which led to the Bank of Canada raising interest rates in early September. Corporate and provincial spreads were very modestly tighter in the quarter. Very low issuance in the summer months was offset by record-setting Canadian corporate issuance for the month of September as a number of first-time issuers accessed the Canadian debt market and other Canadian issuers began to pull forward their debt programs to lock-in rates and mitigate exposure to the rising yield environment. While new issuance has been well absorbed by the market we expect there may be trouble digesting further issuance if it continues around the same pace.
In the quarter, the portfolio generated a return of 1.55% representing an outperformance of 29bps relative to the benchmark. The outperformance was primarily a function of the portfolio’s overweight position to the corporate sector and idiosyncratic single name credit selection opportunities.
2 Source: Aviva Investors, FTSE Russell
We remain moderately constructive on Canadian investment grade credit. Our positive view stems from strong and stable company fundamentals and an improving Canadian economy. However, we do recognize credit spreads have tightened significantly over the last two years, Canadian consumer debt is at all-time highs and geopolitical risks surround the NAFTA renegotiation and North Korea. Portfolio positioning adjustments have been made over the last quarter to take advantage of our updated views. We have increased our investment in US bank debt versus Canadian banks, reduced our long-dated corporate debt exposure and increased our exposure to shorter-dated corporate debt which is less exposed to spread risk but should benefit from positive carry and roll characteristics.
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