Aviva Investors Canada Inc. Fixed Income Quarterly Commentary – March 2018
GLOBAL ECONOMIC REVIEW AND OUTLOOK
Economic Review Q1
Overall economic conditions continued to improve globally in the first quarter. Most significantly, data highlighted rising inflationary pressures in the US, with CPI and wage growth both picking up. This prompted investors to revise their interest rate forecasts. Consensus expectations now suggest the Federal Reserve will raise US interest rates four times this year, compared to the three hikes that were anticipated at the beginning of the year. As expected, the Federal Funds rate was increased by 0.25% in March.
Data highlighted that the Eurozone economy grew at its quickest pace in a decade in 2017. Unemployment has come down, supporting domestic demand. Export demand also remained supportive thanks to robust economic growth globally. While most indicators were positive, some German data showed a little weakness towards the end of the quarter; something for investors to watch in the months ahead.
In the UK, unemployment fell to multi-decade lows. Unsurprisingly, this has filtered through to inflation; CPI increased above the Bank of England’s 2% to 3% target range, before easing back to an annual pace of 2.7% yoy by the end of the quarter. As inflationary forces gathered pace, the Bank of England discussed the possibility of raising interest rates. Minutes from the March meeting showed that two members of the Monetary Policy Committee were in favour of a rate hike. Consensus expectations suggest borrowing costs in the UK will be raised during the June quarter.
Market Review Q1
The first quarter saw an increase in market volatility. Early on equity markets maintained their positive momentum from 2017, supported by favourable economic data and accommodative central bank policy. Sentiment turned in February, however, when stronger-than-expected inflation data in the US prompted investors to suggest that monetary policy might be tightened more aggressively than had previously been anticipated.
Sentiment towards equities deteriorated further in March, after the US said it would introduce tariffs on goods imported from China in an effort to protect US industry and reduce the enormous trade deficit. Chinese authorities responded by introducing tariffs of their own on US imports. At worst, some observers suggested the moves could be the start of a ‘trade war’ between the economic superpowers. This could affect trade volumes globally and, in turn, equity market performance.
With these uncertainties dominating sentiment, all major equity markets lost ground over the period. UK shares performed particularly poorly, likely affected by ongoing Brexit negotiations and associated market uncertainty. The US market performed slightly better, supported by a generally favourable Q4 earnings announcement season.
Bond yields rose in most major regions as investors favoured the relative security of fixed income markets. UK gilts generated a small positive return, for example. Global credit markets performed less well, affected by investors’ moderating risk appetite.
Our central outlook remains one of strong global growth, leading to modestly stronger inflation pressures. Against this background, it seems likely that G10 central banks will be biased towards tighter policy. One consequence of this view that we have highlighted previously is that fundamentals should reassert themselves as the primary driver of valuations and that volatility is likely to edge higher.
Notwithstanding the timing and pace of central bank policy changes, it is clear that we are now progressing along the road of policy normalisation and leaving behind a decade of almost zero interest rates and plentiful liquidity. While these adjustments do not always progress smoothly, fundamentally we believe the developments should be perceived as a positive development on the road to long-term financial stability. The robust global growth backdrop, which is expected to persist in the medium term, is finally helping markets to stand on their own two feet again.
The global growth backdrop remains supportive of equity markets, but the likelihood that volatility will pick up has prompted us to slightly reduce the scale of overweight positioning. The prospects for emerging markets remain particularly compelling and overweight exposure is maintained.
We have seen a fair amount of dispersion in equity market returns, but thus far fixed income assets have exhibited limited volatility. We believe this dynamic is unlikely to persist and that volatility in bond markets will pick up in the remainder of this year. Overall, we do not believe sovereign or credit markets offer value at current levels and continue to hold underweight exposure to both. Japanese government bonds appear particularly unappealing and there is limited value in sovereign bond markets in the Eurozone. The outlook for US Treasuries is marginally brighter, albeit not sufficiently positive to support a positive active position.
In the first quarter of 2018 the portfolio returned 0.09% which was 1bp lower than the 0.10% return of the FTSE TMX Canada Universe Bond Index1. The index return was generated by running yield and roll but mostly offset by slight bear flattening and corporate and provincial spreads that were wider in the quarter. The portfolio’s performance versus the benchmark was positively influenced by new issues in the US market that the portfolio participated in as well as reducing exposure to the real estate sector immediately before the market sell off in late January. These positions were offset by general market widening and exacerbated by our overweight position in the midstream sector that saw selling pressure on higher than expected issuance and negative sentiment due to political roadblocks for planned infrastructure projects. The portfolio’s underweight position in bank deposit notes detracted from performance due to regulatory tailwinds that caused sector spreads to tighten.
Going forward, fundamentals continue to point to a year of strong global growth, with fiscal stimulus in the United States adding to the growth dynamic. With growth expected to remain well above trend in all major economies in 2018, labour markets should continue to tighten as spare capacity is eroded. That is expected to continue to put upward pressure on wage growth and inflation. We expect the shift to tighter monetary policy will be a key market theme in 2018 resulting in more volatility across asset classes. In Canada, we expect growth to lag the US as NAFTA concerns, higher interest rates, and disputes surrounding energy infrastructure projects all conspire to limit growth relative to the United States.
We are moderately constructive on the fundamentals of the Canadian investment grade
credit market due to our base case view of strong and stable company fundamentals and an improving economy. However, our view on fundamentals is largely tempered by tight credit spreads, over-levered Canadian households, trade risks, and inflationary concerns that could all influence credit markets over the coming year.
1 Source: Aviva Investors, FTSE Russell
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