Interest rates in Canada will likely remain low for an extended period of time, as the Bank of Canada appears in no rush to adopt a more restrictive monetary policy in the short or mid term.
Since the 2008 global financial crisis, Canadian investors have enjoyed strong returns amid low inflation and a predictable interest rate environment. Central banks in developed countries moved largely in lockstep, suppressing the yield curve with accommodative monetary policies, including near-zero interest rates. Until recently, stock market returns have been solid here at home and stellar in the U.S. Despite slow growth relative to the U.S., Canada has benefited economically from the fabled stability of its financial system and its resource-heavy economy.
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The impulse among bond investors, therefore, might be to stay the course. But this could be risky. In the post-crisis world, global economies will be operating at different speeds. Central banks are likely to pursue interest rate normalization at different velocities, meaning new opportunities and new risks will present themselves, especially outside of Canada. With domestic yields remaining low (and interest rate normalization being slow) for some time, diversification in global fixed income will create opportunities to drive returns.
Low and slow growth
Post-crisis growth is abnormally lower than it was before the crisis. European growth was negative in 2012 and 2013, and it looks poised to recover to an anaemic 0.8% this year. In the U.S., growth has been steadier: it will likely come in around 2% for 2014. Canada, after besting the U.S. in 2010 and 2011, now seems poised to lag its largest trading partner, with consensus forecasts pegging growth at 2.5% versus 3% for the U.S. in 2015.
Continued deleveraging, government austerity measures, restrictive credit conditions in developed countries and tighter monetary policies in developing countries have—and will likely continue to—put a drag on the global economy. That is doubly true in Canada. Fundamental growth drivers here are gradually strengthening, but achieving growth close to potential will be a slow process. Just when it appears the economy is reaching “escape velocity” toward sustainability, it falls right back down.
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In Q4 2013, Canada’s real GDP grew by 2.9% year over year; in Q1 2014, it had fallen to 0.9% and rebounded to 3.6% in Q2. In August 2014, the economy contracted by 0.1%. Part of this has to do with continuing private sector deleveraging and fiscal consolidation. But the cycle of on-again, off-again growth also feeds on itself. It muddies the outlook, putting downward pressure on business investment, which the BoC has earmarked as a key driver of sustainable growth going forward. Small wonder the BoC has called Canada’s recent economic performance a “serial disappointment.”
Woes, wars and risks
Developed economies also continue to battle chronic unemployment. Canada’s labour market is weak, plagued by an alarming trend toward increasing part-time hiring and a persistent decline in the labour participation rate. Income growth will be muted at best, and absent a tax cut, consumers will have little power to fuel growth.
Aggravating the impact of the weak labour market is the recent decline in oil prices, which hinders business investment. Energy capital expenditures represented about 30% of all business investments in 2014 and should logically be scaled back with the decline in energy prices. That decline has been driven by supply shock (when there is an extreme influx of supply relative to demand), suggesting a price recovery will be difficult without production constraints.
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A weak loonie can go a long way toward mitigating these ills. Robust growth in the U.S. augurs for a pickup in non-energy exports, as auto sales there have rebounded to the pre-crisis sales level of 16 million units annually. Historically, weak domestic growth has eventually been overcome by a pickup in exports as the currency weakens, making Canada’s goods more competitive. But with so many economies plagued with weak growth and monetary stimulus no longer an option, currency wars and beggar-thy-neighbour economic policies are now preferred policy tools. As a result, the loonie remains much stronger than the recent decline in commodity prices would suggest, making it difficult for non-energy exports to offset the anticipated decline in the energy component.
Ultimately, persistent weak growth is the foundation for deflation risks. While inflation expectations are well contained in Canada, it’s a different story in Europe and Japan where, despite aggressive monetary stimulus, inflation remains in a downward trend. The BoC has said it would tolerate inflation running above its target for an extended period of time to support growth. This suggests the BoC is currently more concerned about the economy underperforming relative to its potential.
Investor solutions
The growth landscape globally and in Canada has significant implications for monetary policy. The first and broadest change in monetary policy is the evolution of a period of policy divergence. After years of moving in lockstep to suppress the yield curve, central banks are now poised to go their own way. In October, the U.S. Federal Reserve ended its quantitative easing program, even as the Bank of Japan and the European Central Bank introduced easier monetary policies. This trend will likely increase volatility in fixed income markets, as capital flows seek opportunities.
If Canada is entering an extended period of low yields, this will likely translate into low aggregate returns for fixed income investors. Looking closely at fixed income benchmark indexes for 2014, more than 60% of issues in the Global Aggregate Index yielded between 0% and 2%. Here in Canada, more than 40% of the bonds in the FTSE TMX Canada Universe Bond Index yielded between 0% and 2%.
This low-yield environment is challenging for institutional investors, but there are strategies to cope.
LDI – With no immediate prospect of rates rising, pension plan sponsors should continue phasing in liability-driven investing (LDI) programs to hedge against long-term interest rate risk. For other institutions, the low-yield reality of Canadian fixed income suggests they need to seek returns beyond clipping coupons (i.e., earning the yield of the coupon). Increased volatility in global fixed income may present opportunities for investors to broaden their field of vision.
Global fixed income – Canada accounts for a mere 3% to 4% of the global fixed income market. The Investment Grade (IG) Canadian Corporate Bond Index (FTSE TMX Canada All Corporate Bond Index) is extremely concentrated: there are fewer than 200 issuers, and the financial sector represents about 45% of the index. It also exhibits low dispersion across sectors. With limited opportunities to add value from IG bond selection and relatively few other factors to draw on (e.g., duration and curve), a domestic-focused portfolio is more apt to generate index-like results.
That is one key reason investors should consider going global as they develop their fixed income strategies. Adding global exposures can significantly widen the opportunity set (high yield, global IG credit, emerging markets, mortgages, etc.) and can generate alpha in a low-yield environment, especially as monetary policies diverge and create volatility.
The specific approach depends on the investor’s purview and mandate. For investors who are benchmarked—for example, to the FTSE TMX Canada Universe Bond Index—one path is to implement a core-plus solution, exposing the portfolio to global fixed income assets while still staying true to the benchmark characteristics.
Non-benchmark investors might consider adopting an even more globally oriented solution to fully harness the benefits of risk diversification across market environments. This requires a more flexible approach in which fixed income assets are allocated to different regions and sectors to enhance returns. Assets may be allocated globally to a wide spectrum of fixed income classes, most of which aren’t available in Canada.
This approach also presents the opportunity to mitigate duration risk, which is high in a traditional bond portfolio. Compared with an index duration of more than seven years for the FTSE TMX Canada Universe Bond Index, a flexible portfolio of diversified global fixed income classes can reduce duration risk to less than a year without sacrificing yields.
The fixed income landscape is shifting. Uncertainty at home and abroad has an impact on monetary policy, and central banks are no longer so eager to sing from the same song sheet.
Canadian investors will have to get used to the new normal—and, to succeed, they should consider opportunities on the global stage. While interest rates and hikes in Canada may be low and slow, there’s no reason investors’ returns or the speed of their response has to be.
Aubrey Basdeo is managing director, head of fixed income, for BlackRock Canada.
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