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Aviva Investors Canada Inc. Fixed Income Quarterly Commentary – September 2019

Date: July 25, 2019


Economic Review Q2

Now below three percent, the annual pace of global growth has slowed to a seven-year low. The trade dispute between the US and China has dampened trade volumes, in turn affecting manufacturing activity. The trade conflict worsened during the September quarter, with US President Trump announcing that tariffs would be broadened to cover imports of all Chinese goods. Following Chinese retaliation, the proposed tariff rates were subsequently increased across the board, to an average of around 22 percent. Combined with weaker-than-expected growth in the Eurozone, this has prompted us to revise down our global growth expectations until the end of 2020.

Global export volumes have deteriorated sharply. In fact, only during the global recessions of 2001 and 2008/09 have they been lower in the past 30 years. The introduction of US import tariffs around a year ago accelerated the decline in export volumes globally as orders declined. Unsurprisingly, the impact has been felt most acutely in countries and regions reliant on external demand as the primary source of growth. Japan and other parts of Asia, as well as Europe, have seen a sharp decline in growth as exports have become a material drag. International trade represents a smaller part of the US economy, but lower trade has nonetheless weighed on overall growth. Significantly, business investment in the US and elsewhere has slowed as uncertainty has impacted spending decisions.

Despite the slowdown in growth, no major economies have seen material increases in unemployment. This reflects robust consumption, supported by improvements in real disposable income and solid household balance sheets. Services sectors have been quite resilient, though the current slowdown could turn into something more serious if they started to see deterioration.

Weaker growth prospects and low inflation have prompted central banks to ease policy settings. The Federal Reserve reduced rates by a quarter of a percentage point in both July and September and some Board members indicated a willingness to ease policy further. Money markets are suggesting the Federal Funds rate could be lowered three or four more times in the next year. The European Central Bank also eased policy in September, cutting policy rates by 10bps and taking them further into negative territory. It also announced a recommencement of its asset purchase program and adjusted its balance sheet operations to ease bank funding. The People’s Bank of China has also undertaken a range of policy easing measures in recent months, as have other central banks including the Reserve Bank of Australia and the Reserve Bank of New Zealand. This monetary support saw risk-free rates fall sharply worldwide, with sovereign bond yields reaching new lows in many cases.

Market Review Q3

Despite weakness across Asia and the emerging markets, global equities edged higher in aggregate in the third quarter. The MSCI World Index returned 0.7% in US dollar terms. While economic indicators were a little concerning, investors seemed reassured that central banks were willing to ease policy settings to boost activity levels and hopefully avert a more pronounced slowdown in growth. Sentiment towards equity markets was also supported by the release of generally pleasing corporate earnings announcements in the US.

International government bonds generated even stronger returns than global share markets during the quarter, reflecting a sharp drop in bond yields globally. In the US, for example, benchmark 10-year Treasury yields plummeted as interest rate expectations were revised lower. German and Japanese 10-year government bond yields plunged even further into negative territory.

The moves were reflective of deteriorating economic data in most key regions. Several countries in the Eurozone are on the brink of recession, following negative growth rates in the June quarter. Export demand has been affected by a slowdown in China. It also remains unclear how the Brexit process will play out and how this might affect growth rates in both the UK and Continental Europe. Asian economies also appeared to be affected by the ongoing trade standoff between the US and China. With global trade volumes being adversely affected by the conflict, conditions generally deteriorated in export-oriented economies. In many cases the worsening outlook resulted in lower bond yields and, in turn, favourable returns from fixed income markets.


We now expect growth to remain below three percent for the next 18 months. All major economies are likely to grow below potential in 2020 – unemployment looks set to rise modestly in key regions and wage and inflation pressures are likely to remain muted. Whilst acknowledging that the risk to these forecasts is to the downside, we still believe a mild global recession is unlikely.

The ongoing US/China trade dispute remains a potential headwind to growth and, in turn, equity valuations. While trade talks have resumed, the risk of an escalation in tensions remains high. The outlook for global trade volumes remains negative, as shown by recent manufacturing surveys in Europe and Korean export data. Other potential geopolitical flashpoints – a spat between Japan and Korea and clashes between the US and European Union, for example – also warrant attention. Various other issues could also erode sentiment, such as an intensification in tensions between Saudi Arabia and Iran, as well as Brexit.

The economic divergence between the US and other regions only appears to be growing. A range of leading indicators in the US have surprised to the upside recently, while there have been few signs of stabilisation elsewhere. European data is particularly concerning and recession risk in Germany remains high given the slump in the manufacturing sector.

Consequently, we are quite positive on the prospects for the US dollar. Periods of subdued global trade growth have historically been correlated with US dollar strength and 2019 has been no different. The Federal Reserve is not expected to be as accommodative as central banks in Europe and China, suggesting the dollar could be supported.

The silver lining for financial markets is that a policy easing cycle is underway globally. With central banks across developed and emerging markets lowering interest rates, we have a constructive view on bond markets.


Performance summary: Outperformed the index by 11bp for the third quarter, bringing year-to-date performance to +46bp versus the index.

Contributors: Security selection contributed to performance, particularly within the retail, communications, oil & gas and Canadian banks. Broadly speaking, exposure to corporate bonds on the 1 to 10-year part of the curve outperform due to carry and roll despite credit spread widening. Sector allocation also contributed to performance, as our overweight position in corporates was modestly offset by our underweight position in government bonds.

Detractors: Exposure to some US dollar investment grade bonds (Energy Transfer Partners, Cigna and HCA) detracted from performance.

Outlook/positioning: Credit risk positioning slightly increased due to the dovish stance of central banks but remains low relative to the index. Our corporate positioning has slightly increased in the 10-year and 30-year KRD in attractive new issues. Additionally, we’ve slightly decreased our exposure to provincials, mainly in the 2-year and 10-year part of the curve.

Performance summary

Canadian credit spreads slightly widened during the quarter on the back of growing concerns around the sustainability of global growth and continued trade tensions. However, carry and roll for credit product on the 1 to 10-year part of the curve more than offset the small spread widening during the quarter. Central banks globally continue to be accommodative through lower interest rates, supporting valuations in credit markets despite weakening economic fundamentals. In fact, additional support from central banks supports provincial bonds given the perceived lower probability of a downside economic scenario. However, should the Bank of Canada adopt easing measures in line with other central banks, we could see increased pressure on provincial bonds and the possibility of deteriorating Canadian bank assets should consumer leverage increase in a lower interest rate environment. 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 by 11bps, gross of fees, a result of both security selection and sector allocation.

Attribution commentary

In the third quarter of 2019, both security selection and sector allocation had a positive impact on performance. With regards to security selection, our US IG positions detracted 5bp of performance, particularly Energy Transfer Partners, while our high yield positions contributed 4bp, mostly due to our Viking cruises exposure. The balance of our added value came from our Canadian dollar exposure, predominantly GTAA, Gibson energy, Transurban and Enbridge.

From a sector allocation standpoint, our overweight to corporate bonds contributed positively to performance but was modestly offset by our underweight position in government bonds, in part provincial bonds. Our underweight position in provincial bonds 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.

Positioning commentary

Since the end of the second quarter, our overall credit risk positioning slightly increased due to the dovish stance of central banks but remains low relative to the index. Our corporate positioning has slightly increased in the 10-year and 30-year KRD in attractive new issues. Additionally, we’ve slightly decreased our exposure to provincials, mainly in the 2-year and 10-year part of the curve.

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 select pipeline exposures, infrastructure, retail, communications and US financials. 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. 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. In fact, current valuations reflect the continued belief of further central bank easing despite weakening economic fundamentals. As such, we are positioned slightly more conservatively until such time that valuations warrant an escalation in the overall risk profile of the portfolio with an approach for carry and roll-down in corporate credit spread, currently optimal in the five-year part of the curve. The risks associated with Canadian financials and provincials, while highly contained for now given the renewed low rate environment, remain an area of close focus for us for potential future deterioration from current valuation levels. 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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Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in security value and reinvestment of all distributions/dividends and do not take into account sales, redemption, distribution or optional charges or income taxes payable by any security holder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Information contained in this publication is based on sources such as issuer reports, statistical services and industry communications, which we believe to be reliable but are not represented as accurate or complete. Opinions expressed in this publication are current opinions only and are subject to change.

Stone Co