ECONOMIC & FIXED INCOME COMMENT: What is the “missing ingredient” for global growth?
Low growth has been one of the factors that has held back the Federal Reserve from raising rates so far this year. Another is inflation; currently the “All items” CPI in the US is expected to be 1.4% in 2016. However, if you look at “Core” CPI, which excludes food and energy, CPI moves up to 2.2%. The major difference between the two measures of inflation is energy. With the sharp decline in oil prices in 2015, the current CPI “All Items” is reflecting this deflation. Oil prices made a bottom in February 2016 near $25 per barrel. However, if oil prices remain at their current level of $50 by February 2017, we have a 100% increase in the price of oil from February 2016 supporting economists’ forecasts for “All Items” and “Core” CPI in the US to be over 2% in 2017. There is chatter of a potential Fed rate hike in December (60% odds priced into bonds currently). Until now, the Federal Reserve has remained “data dependent” and concerned with global market volatility. However, higher inflation statistics, as mentioned earlier, could force the Federal Reserve to increase rates at a faster pace in 2017.
We have only a few more weeks before the November 8th Presidential election to know whether or not the world will be subjected to Donald Trump. The polls have been very close but recent news that he has not paid income taxes in many years, the suspension of his charitable foundation from taking contributions and the loss of support from key Republicans may be enough to sink his ship. As Brexit has taught us, nothing is for sure. In our last “Economic Comment”, we mentioned the unknown size of the disenfranchised factory worker vote. Let’s hope that there will be a stock market rally on November 9th.
The Canadian economy bounced back in the third quarter after contracting -1.6% in Q2 due to the wildfires. The Bank of Canada was expecting a substantial rebound in the second half of the year due to the oil production recovery, rebuilding in Alberta, the commencement of the enhanced child benefit payment and federal infrastructure spending. However, the September statement from the Bank of Canada was dovish indicating strong headwinds to growth and downside risk to inflation. We do not anticipate the Bank of Canada will raise rates this year or in 2017. As a result, Government of Canada 10 year bonds should trade in a range of 1.0%-1.3% well into 2017.
Finally, we turn to Europe and Asia. The Prime Minister of the UK, Theresa May, announced on October 2, 2016 that the UK will exercise Article 50 of the Lisbon Accord starting the formal two year exit from the EU before March 2017. Also, her government has decided to take a “hard Brexit” stand with the negotiations. Her government has rejected the “soft Brexit” strategy which allows the free flow of labour. “We are not leaving the European Union only to give up control of immigration again.” We now have a timeline and a strategy position which is useful for UK business decision making. However, there is still one wild card outstanding. Theresa May could call a snap election in the spring and make Brexit the key election issue. The Bank of England (BoE) will continue to provide monetary stimulus to support the economy while navigating through Brexit. The European Central Bank is likely to remain on “monetary ease” well past its original March 2017 cut off, with the Bank of China and the Bank of Japan following suit. All of these economies are battling sluggish economic growth and below target inflation rates.
Within the third quarter, corporate and provincial bonds continued to provide strong performance for investors as spreads narrowed further. Both short/mid corporate and provincial bonds outperformed Government of Canada’s. It is important to note the strong performance of BBB and energy bonds during the quarter. These sectors of the bond market are continuing to recover from the sharp decline in values in 2015. Going forward, we will continue to emphasize corporate and provincial bonds relative to Canada’s and extend the duration of the bond portfolio as global economic growth and inflation are projected to remain low.