FIXED INCOME COMMENT- The year of the “Black Swan”
Black Swans are rare as are some of the global events of 2016-Brexit, Trump win and the Italian Constitutional Referendum to name a few. Albeit slow to start, global growth did pick up in the second half of the year to meet estimates of 3.1%. The rebound was primarily driven by accommodative monetary policy, increased fiscal spending, recovering commodity exports and expanding industrial production in advanced economies. Moving into 2017, these factors should continue to support global expansion with forecasts of 3.3% and 3.5% growth in 2017 and 2018, respectively.
The U.S. continues its recovery from a sluggish first half. The fourth quarter is on track to produce a solid 2% pace making economic growth for the year roughly 1.6%. The main driver helping growth was consumer spending and it will remain a key contributor in 2017. Business investment was disappointing in 2016 (spending cuts in the energy sector) and will likely advance in 2017 in part due to Trump policies. Although the U.S. economy has improved to a point where emergency low level interest rates are no longer necessary, the Federal Reserve Board will remain cautious with the pace of increasing the Fed Funds Rate. There are several factors that could impact policy tightening. These include:
global flow of funds moving into high yielding Treasury bonds-adding upward pressure to the U.S. dollar.
another sharp increase in inflation expectations-impacting lending rates and curtailing economic growth.
unanticipated global events that could materialize at any moment-impacting confidence and increasing market volatility.
If there is moderate to slightly faster U.S. growth, we believe the Fed will raise the Fed Funds Rate 2 times in 2017 bringing it to 1.25%. However, if growth is slower, we believe the Fed will raise rates once and if growth is faster, 3 times. We believe the U.S. 10 Year Treasury bond will trade in a range of 2.4% – 3.0% over the next 12 months.
Canada has been able to recover from the Q2 Fort McMurray wildfires that wreaked havoc on growth. For 2016, Canada’s economy is expected to expand 1.3%. Our forecast for 2017 assumes growth will pick up to 1.8%. The main forces behind the acceleration include an increase in government expenditures as fiscal stimulus ramps up, strengthening exports, and a modest gain in business investment. However, rising U.S. protectionism may temporarily weigh on business investment until there is a clearer picture on policies from the new President. We anticipate the Bank of Canada to be on hold through 2017 and maintain the overnight rate at .50%. With U.S. Treasury bond yields trending upward due to increased inflation expectations (Trump effect), Canadian yields will follow in lockstep. The Canadian 10 Year bond is expected to trade between 1.7%-2.1% in 2017.
Within Europe, highly accommodative monetary policy remains in place and inflation forecasts have been left unchanged. In early December, the European Central Bank (ECB) extended the Quantitative Easing (bond buying) program from March 2017 to December 2017 however, trimmed the pace to €60 billion per month starting in April 2017 from the current €80 billion. For 2017, monetary policy will remain the primary source of stimulus with economic growth estimated at approximately 1.5%. Continuing to jeopardize growth are undercapitalized banking systems, high government debt levels and poor demographics.
China’s transition to a consumer based economy continues to transpire with the contribution of exports to the economy falling to the lowest level since 1999. This is good news for China with the “anti-trade” rhetoric brewing in the United States. However, with the transition, three major concerns are developing. First, debt has soared since 2009 and now accounts for 145% of China’s GDP. Second, will China be able to maintain the 6.5% growth objective? Third, China’s demographics are deteriorating due to the 1 child policy. Specifically, the working age population is expected to decline over the next 4 years-possibly impacting potential GDP growth. These are important to consider as China is the second largest economy in the world. The IMF estimates a 1% reduction to China’s growth could impact global GDP by nearly 0.25%.
Examining the various economies, we continue to see divergence in monetary and fiscal policy. Within the major markets, the U.S. and China are expected to raise interest rates, the U.K. is favouring rate cuts while Canada and the ECB will be on hold for 2017. Examining fiscal policy, the U.S. will join Canada, China, Japan, and South Korea in providing stimulus to boost their economies. The question remains, will these measures cause inflationary pressure? Investors will have to wait and see.
This was the year of Corporate bonds, quite a different story compared to last year. In 2016, mid-term Corporates (5-10 years) returned 4.29%, mid-term Provincials 1.53% and mid-term Canada’s -0.06%. Regarding short term (1-5 years) bonds Corporates returned 2.52%, Provincials 0.87% and Canada’s 0.13%. Within corporate bonds, the energy (TransCanada and Enbridge) and telecommunication (Telus and Bell) sectors were the best performing. Going forward, we will continue to overweight corporate and provincial bonds relative to Canada’s. With the current level of uncertainty in the U.S. and Europe, we are taking a cautious approach to the bond market. We will allow the duration to decline over the next 6 months. During that time, we will continue to monitor global economic growth prospects, focusing on policy changes in the U.S.