Aviva Investors Canada Inc. Fixed Income Quarterly Commentary – December 2017
GLOBAL ECONOMIC REVIEW AND OUTLOOK
Economic Review Q4
The momentum of global growth remained both positive and broad-based in the fourth quarter. In the US, third-quarter growth was reported to be strong at an annual rate of 3.0%, with the economy continuing to add more jobs than expected. The US Federal Reserve met most expectations by raising interest rates for the third time in the year in December. Strong business sentiment surveys suggested that the Eurozone had picked up again strongly in the fourth quarter after a slight dip in Q3. The European Central Bank (“ECB”) responded by halving the scale of its monthly quantitative easing, although it extended the timeline of the policy by nine months. Inflation nevertheless remained stubbornly below target as spare capacity continued to wash around the Eurozone economy. Economic data in Japan was almost universally positive, with unemployment falling to a cyclical low and inflation starting to return. Asia was supported by encouraging growth numbers and the stable performance of the Chinese economy.
Global commodities performed well in the fourth quarter, with both energy and industrial metals making attractive gains. Brent crude was buoyant as OPEC countries agreed to further production cuts and overall supply was threatened by political protests in Iran. With global risk appetite having strengthened, precious metals only made modest advances.
Market Review Q4
As 2017 drew to a close, global risk appetite remained positive, with most equity markets posting gains in the fourth quarter, after having made good gains across the year as a whole. However, fixed income markets struggled to make headway as investors anticipated higher inflation and tighter monetary policy conditions in 2018.
The strongest returns in local terms were posted by Japanese and emerging market equities. Japanese shares were buoyed by strong corporate earnings and the victory of the incumbent LDP party, which was expected to push through further economic reform. The strengthening of international demand and an improving political backdrop underpinned the good performance of emerging markets. Europe posted disappointing returns; however, as a stronger euro weighed on the value of international earnings and political uncertainty hung over Germany, where Chancellor Merkel struggled to form a government.
US Treasury bonds fell during the quarter on expectations of tighter monetary policy in response to the prospect of stronger growth and rising inflation. Returns from European government bonds were only modest as the European Central Bank was poised to halve the scale of its monthly asset purchasing from January 2018.
Our global growth outlook for 2018 is strong. The broad-based, synchronised upswing that began a year ago shows no signs of easing, with above-trend growth expected to extend from the major G7 economies to the emerging markets over the course of the year. That should see global growth approach 4 per cent, the strongest since 2011 and consistent with a continued reduction in global slack, increased inflationary pressures and a geographical broadening in the removal of extremely accommodative monetary policy.
Expectations of stronger global growth and modestly higher inflation in 2018 provide a positive environment for risk. Moreover, with the improvement in the global economy and the peak of monetary policy accommodation likely behind us, we would expect asset markets to be driven more by the underlying fundamentals than at any point in the past decade. In terms of equity markets, that should mean a focus on the earnings outlook, valuations and sector allocations is likely to be increasingly important.
Lower-risk assets are likely to have a more difficult year, however. Arguably the most challenged is Eurozone government debt, where yields continue to be suppressed by ECB asset purchases. Investment grade corporate credit in both the US and Europe is also likely to face headwinds in 2018 given the spread tightening seen over the past year. In Europe, there is the added risk associated with the expected end of ECB purchases later in 2018. High yield credit is relatively more attractive given the potential for some further narrowing in spreads and the low probability of a material default cycle starting in 2018.
In the fourth quarter of 2017 the FTSE TMX Canada Universe Bond Index generated a return of 2.02%.1 Despite strong Canadian employment numbers and rising probability of Canadian rate hikes in 2018, long-term rates declined which boosted the overall index return.
The portfolio returned 2.07% in the quarter. Corporate and provincial credit rallied across sectors which benefited our overweight risk position in the portfolio. This was partially offset by both our underweight position to Canadian bank deposit notes which benefited from new regulations that benefit existing bonds and our underweight position to provincial credits, especially in the 10-year area, that benefited from improving provincial finances. The holdings denominated in the United States hurt overall performance due to a changing basis between US and Canadian rates as well as idiosyncratic company changes.
The portfolio had an average yield to maturity of 2.74% as of December 31, 2017 above the benchmark yield of 2.47% and had an average credit rating of A versus the benchmark yield of AA-.
We remain moderately constructive on the fundamentals of the Canadian investment grade credit market. Our positive view stems from strong and stable company fundamentals and an improving Canadian economy. The positive view is tempered by credit spreads that have tightened significantly since their early-2016 levels and are near post-financial crisis tights; the stretched balance sheet of the average Canadian household; concerns around geopolitical events, and in particular, the impact of a protectionist Trump agenda for Canada; and the impact of higher rates on credit spreads as international investors are able to reach yield bogey targets with lower risk investments.
1 Source: Aviva Investors, FTSE Russell
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