Global: We have found growth but, has inflation lost its way?
Global growth has since recovered from the disappointing 3.1% in 2016. Leading the pack are the G7 nations that have outperformed trend growth, despite unrelenting geopolitical risks (Brexit, Trump etc.). Global growth is forecasted to be 3.4% in 2017. Supporting this progress includes: accelerating business investment, declining unemployment rates and positive business activity. However, inflation readings among the G7 and key Emerging Markets have come in well below expectations, allowing for a strong market rally in long term bonds. The disappointing inflation can be attributed in part by the pull-back in oil prices however; underlying core inflation measures have also been below forecasts.
Examining the different advanced economies, we will continue to see divergences in monetary policy during Q3 and Q4 of 2017. The Bank of Canada has joined the U.S. on July 12th in raising interest rates due to strong economic data and a desire to reduce the use of credit. On the other hand, the European Central Bank, Japan and U.K will continue to provide stimulus to support their economy.
America: “Slip Slidin Away”
When we think of President’s Trump performance so far, this song from Simon and Garfunkel comes to mind. Between the Russian inquiry and the lack of ability to get anything through Congress, his election promises are slipping away. Tax reform, reduced regulation for the financial services industry and repatriation of offshore corporate profits are likely pushed further down the road.
As a result, the U.S economy is faced with a continuation of slow growth and low inflation. Current forecasts have GDP growth in 2017 and 2018 at 2.2% and 1.9% respectively. These forecasts are substantially less than President Trump’s 3% GDP goal. (Most economists thought this goal was unrealistic!) The Fed’s highly anticipated interest rate increase in June from 1% to 1.25% seems inconsistent with the current economic data. The Fed was not concerned with the recent data and expects the US economy to continue to absorb economic slack over the next few quarters. What the Fed is doing is removing the emergency low level of interest rates which were used to support the U.S. economy after the 2008/2009 recession. However, the inflation data in May was surprisingly low; the core rate declined to 1.7%--the lowest reading in 2 years. The sluggish advancement of inflation will ensure the rise in interest rates will be slow, steady and data dependent. Our expectations place the target rate of the Fed Funds Rate at their long term inflation goal of 2%. We anticipate the uncertainties surrounding the inflation outlook will weigh on the bond market in the short term.
Canada: “Shifting Monetary Gears”
The Canadian economy started off the year quite strong (3.7% annualized in Q1 2017) and has maintained its momentum in Q2 2017. As a result, the growth forecast for 2017 has been revised upward to 2.8% - placing Canada at the top of the leaderboard among the G7 nations. The main contributors were: consumer spending, residential housing and business investment (both machinery and equipment). Most notably, business investment rose 10% (annualized rate) –the largest increase in 5 years. The higher level of growth has caused the Bank of Canada to re- consider their interest rate policy with an increase from 0.5% to 0.75% and the prospect of another 0.25% increase in the fall. Again, this move by the Bank of Canada is a reversal of the emergency low interest rates following the financial crisis and the sharp decline in the oil price in 2014 and 2015. While our inflation rate is relatively low (May 1.3% -6 month low), this rise in the Bank Rate will be helpful in cooling the housing markets in Toronto and Vancouver.
A sub plot to the Bank of Canada move at this time is the concern they will be accused of currency manipulation by the Americans as we start NAFTA negotiations in August. The 0.50% reduction in the Bank Rate in 2015 caused the Canadian dollar to decline 13.6% over calendar years 2015 and 2016. Clearly, this was great support for our exports which strengthened the economy however; we feel the Trump administration will take offense at this policy.
What do these developments mean for the bond market? Although global growth is above trend (especially within the G7 nations) inflationary pressures have not gained traction. At the start of the year, global bond yields were expected to trend upward; however this has not been the case. Short term yields have risen and long term yields have declined causing a “flattening of the yield curve” (see chart). The difference between 2 year bonds and 30 year bonds was 1.55% at the beginning of the year. At the time of writing the spread had narrowed to 1.02%. The narrowing was caused by a rise in the 2 year yield from 0.76% to 1.04% (reversal of emergency policy) and a decline in the 30 year yield from 2.3% to 2.06% (low inflation expectations).
Moving into Q3, we will allow the bond portfolio duration (interest rate sensitivity) to fall through the passage of time relative to the benchmark. We will continue to monitor the economic and inflation statistics with a view to shifting to a more defensive strategy if the data warrants. Lastly, we will continue to emphasize corporate and provincial bonds as they offer higher running yields than Government of Canada’s.