- Investors’ reduced appetite for risk in some ways appears to be an overreaction and could prove beneficial for some sectors within the Canadian fixed-income market.
- Our base case, which is more dovish than most, is for the Bank of Canada to raise interest rates only once in 2019, while the chance of a second hike has been significantly diminished over the last month or so. However, we don’t view these rate hikes as material threats to top-level economic growth.
- Canadian corporate bonds currently appear somewhat undervalued given Canada’s strong economic fundamentals, while the energy sector could offer compelling opportunities in 2019.
A reduction in risk appetite could be supportive of fixed-income assets
After a challenging fourth quarter, global equity markets appear to have stabilized in the early days of 2019—at least for now. Growing concerns about the U.S.-China trade war, potential policy missteps by global central banks, and worsening economic outlooks for developed European and Asian economies have brought with them a wave of heightened volatility. Investor sentiment is showing signs of calming, but it’s unclear if risk appetites will continue to grow.
While such a combination often makes for challenging conditions for equities and other risk assets, a lower-risk environment can be supportive of fixed-income investments. In our view, economic fundamentals in Canada and the United States remain quite healthy, and we think a recession in either country over the near term is unlikely. Investors looking to reduce risk without fully heading to the sidelines may increasingly turn their attention to the fixed-income markets and, in particular, the corporate space. Any uptick in demand would be welcome news for existing bondholders, particularly against the recently witnessed backdrop of rising interest rates and widening corporate spreads.
“The Bank of Canada isn’t as tied to providing forward guidance as the U.S. Federal Reserve, and has more flexibility to pause its tightening policy in the face of heightened volatility.”
The Bank of Canada: only one rate hike likely in 2019
Although growth in Canada has slowed and there are pockets of weakness that require watching—namely, housing and consumer debt—there’s little reason to believe that a recession is just around the corner.
However, the sell-off in the equity markets experienced late last year revealed just how skittish investors have become. The Bank of Canada (BOC) isn’t as tied to providing forward guidance as the U.S. Federal Reserve, and has more flexibility to pause its tightening policy in the face of heightened volatility. For this reason, the BOC left interest rates unchanged at 1.75% at its recent meeting on January 9. We view a hike at some time in the spring this year as most likely but, beyond that, we expect the BOC to hold off raising rates for the remainder of 2019, ending the year with its benchmark rate at 2.0%.
The $64,000 question is, can the Canadian economy withstand two rate hikes this year if the BOC decides to do so? In our view, the answer is yes— but two rate hikes might nudge the Canadian economy into the danger zone. A benchmark lending rate just north of 2.0% is still low by historical standards, and the broader fundamentals in the Canadian economy are in better shape today than they’ve been for much of the past decade, but there remain risks the BOC will be sensitive to.
Canadian corporate bonds have better profiles than their global peers
One market segment that we’re monitoring closely is Canadian corporate bonds. While the market has come under stress recently, we believe it has the potential to outperform. Canadian corporate bonds typically have better credit profiles relative to their global peers and that’s a key reason why we don’t expect to see many “fallen angels” in Canada (when the credit rating of BBB-rated investment-grade debt is cut to junk status).
That said, the Canadian corporate bond market won’t be completely immune should a wave of credit downgrades in the United States lead to forced selling in investment-grade strategies, sparking a broader market sell-off. The market for Canadian corporate debt is less liquid relative to its U.S. counterpart and is therefore more likely to experience liquidity shocks in times of stress. There’s no doubt that the issue warrants close monitoring, but we believe any developments in the BBB segment of the market will play out over an extended period of time rather than in a violent, one-off occurrence.
Canada’s energy sector: opportunities could be emerging
Although investors have been giving the country’s oil and gas industry a wide berth in recent years, we think compelling opportunities have been emerging.
Canada’s inability to transport its energy products in a cost-efficient manner to the global marketplace is well known. It doesn’t help that efforts to build the appropriate pipeline to resolve the issue have also been consistently stymied by political disagreements between provincial governments and environmental organizations. This is a major reason why crude oil produced in Canada often trades at a discount to energy produced elsewhere.¹
In our view, the dislocation between sector/company fundamentals and sentiment could be excessive. Comments made by senior industry executives and data within publicly available financial statements mostly support that perspective. We’re monitoring developments in the sector very closely and believe opportunities are beginning to reveal themselves and will intensify over the next few months.
There can be little doubt that the global macroeconomic environment is challenging, but barring a complete breakdown in trade negotiations between the United States and China, there’s little reason to believe that we’re on the brink of falling into the abyss. Caution, naturally, is warranted. But as experienced managers, it’s also our responsibility to cut through the noise of geopolitics and demonstrate the value that active management can offer during trying times. As hindsight regularly proves, opportunities can be borne out of volatility and excessive pessimism.
1 Western Canadian Select is the main benchmark for oil produced in Canada, while global energy producers mostly use WTI (West Texas Intermediate) as a point of reference.
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