ECONOMIC & FIXED INCOME COMMENT: “Is the Glass Half Full or Half Empty?”
Up until the end of the third quarter the world was convinced that the glass was half full. Then abruptly, it switched to half empty. While there has been a long list of concerns in the marketplace this year, it was the prospect of a long and difficult trade war between the U.S. and China that tipped the Global stock market over in the fourth quarter.
Let’s be clear, the expected slowing in Global growth has been well understood for a number of quarters. The IMF has a forecast of 3.7% growth for 2018 and coming down to 3.4% in 2019. The selloff in the stock market was an overreaction as a risk of a recession in both 2019 and 2020 is low.
November brought a dramatic shift in central banks’ views of the economy due to their heightened concerns of the issues mentioned above. The tone of their commentary became more dovish which suggested they will be taking more time to increase interest rates.
While bond yields were declining through November, the U.S. request for Canada to arrest the CFO of Huawei in Vancouver on Dec 1st changed the intensity of the U.S. – China trade war. As a result of this event, bond yields declined more sharply. The Government of Canada ten year bonds began in 2018 at a yield of 2.04% and reached a high of 2.57% in October. Currently, the 10 year bond is trading at 1.96%.
We believe both the Federal Reserve and the Bank of Canada (BofC) will hold their current interest rates of 2.5% and 1.75% respectively until the end of the first quarter. If the economic data is consistent with a slowing economy and NOT a recession, there is room for at least 1 more Fed Funds increase in 2019. The BofC would probably like to close the 0.75% difference in the central bank rates to 0.5%. Therefore, the BofC could increase our Bank Rate by 0.5% during 2019.
While the speed of interest rate hikes are slowing, the question is – when do they stop going up? We have talked about the neutral Bank Rate in Canada and the Federal Reserve Rate in the U.S. before. This is the central bank rate which will not stimulate growth or restrict growth. The graph reflects the speed at which the marketplace has drastically reduced their expectation of where the “neutral rate” for monetary policy should be from 3% in October to 2.65% in December. This suggests that we are closer to the end of rising interest rates at this time.
Looking ahead, the Global economy has a number of headwinds to deal with in 2019; the U.S.-China trade war, BREXIT, Russia Military action and oil prices. While central bank rates have increased in 2018 and possibility a little more in 2019. The real rate of interest is quite low and supports economic growth. Unemployment in both U.S. and Canada are at multi decade lows, inflation is well contained around 2% and GDP growth for 2019 & 2020 are forecast at 2.4% and 1.8% in the U.S. and 1.8% and 1.6% in Canada.
Bonds in the mid-market (5-10 years) were the best performers in the quarter. Short term bonds and mid-term bonds produced the same returns of 1.91% for the year.
The best performing sector of the bond market were long Canada bonds (over 10 years). For the year they generated 3.36% return, however all this return was produced in the month of December (3.53%). Clearly, this is a sector which is likely to underperform in 2019.
With the prospect of one or two increases in the U.S. Fed Funds Rate, we are maintaining are defensive term strategy and overweighting Provincial and Corporate bond sectors to increase the yield of the portfolio. We are coming to the end of a credit cycle so investors need to pay extra attention to credit quality as governments; corporations and individuals have taken on considerable debt.