Market Review
Global economy switching to a lower gear
Over the last 18 months, most economists warned that a major global setback was right around the corner. The alarm was defensible. As central banks hiked interest rates at an historic pace, the reflex view has been that it will cause a disruption in financial markets. But the big surprise has been the resilience of the world economy. Households and corporations are still in good shape. Jobs are plentiful and wages remain high. Rising rates are having little effect on companies and mortgage holders who locked in low interest rates.
The gross domestic product (GDP) outlook has now shifted from recession scenarios to one of modest growth. The lagged effects from rate hikes are expected to cool activity and pinch expansion plans. North America had a standout economy last year but is expected to downshift and deliver 1% GDP growth this year.
Meanwhile the Euro zone avoided a recession last year as it managed its energy supply dislocations well. This year will feature some of the same challenges but improvements in real wages and household incomes are expected to help deliver modest growth.
China suffered its worst housing downturn last year but still posted average growth as economic activity bottomed over the summer. It is entering 2024 with more momentum as government economic policy has turned more friendly.
Unsynchronized sector adjustments
When looking ahead to understand the current economic cycle, particularly in the U.S., we see what looks like a series of unsynchronized sector adjustments or a “rolling recession.” We characterize this as a version of a soft landing with pockets of economic weakness but not a systematic downturn.
For instance, a major correction in the technology sector in 2022 led to job losses. But jobs in the sector recovered as enthusiasm for artificial intelligence picked up. Housing prices dropped from cycle highs, but recovered on the back of lower inventory. U.S. manufacturing has been in contraction territory for over a year but is edging up from last summer’s lows. And regional banks, after recent failures, are shoring up their balance sheets as new regulatory capital requirements are proposed.
Central banks close to peak rates
The fight to bring down inflation recently stalled in Canada due to a tight labour market and wage gains. But hiring in Canada has started to slow and hours worked has dropped. Strong immigration has also boosted labour supply.
Europe’s inflation picture also improved. Headline and core inflation dropped to its lowest levels in over two years. The fall in inflation has been broad-based. Goods and services inflation have fallen and wage pressure has slowed. Rate hikes from the European Central Bank’s (ECB) helped rein in borrowing and demand.
Central bank policy to remain a critical market driver
While major central banks still warn the world that inflation is a threat, traders are ramping up bets that rate cuts will begin in 2024. It is surprising how quickly and consistently this shift has happened. Markets expect that the U.S. Federal Reserve (the Fed), Bank of Canada (BoC), Bank of England and European Central Bank will each cut rates by 100 basis points or more this year.
The market is convinced that the cumulative effects of central bank rate hikes will fully kick in this year. This could weigh on economic activity and labour markets and urge central banks to be accommodative.
Market Outlook
In a year that saw many central banks finally put a cap on their interest rate hiking activities, the Canadian and the U.S. economies ended 2023 looking resilient. Inflation seemed to be on the decline globally. Canadian growth, while clearly impacted by the BoC’s hiking cycle, avoided a recession as employment remained relatively robust. Canadian bond markets showed unexpected strength in Q4 2023. On the rates side, there was a reversal of the Q3 2023 selloff as markets rallied towards the end of the year. Canadian five-year bonds were the top performer with yields dropping 110 bps in Q4 2023, as investors anticipated rate cuts even as inflation hovered above the BoC’s inflation targets.
On the credit side, the recession that never came was very positive for markets. Relatively steady economic fundamentals and slower new corporate issuance supply in Q4 2023 helped Canadian corporate credit spreads to tighten by 15 bps for the quarter and 29 bps for the year, according to the Bloomberg Canada Aggregate Corporate Index.
Fund Review
Sun Life Core Advantage Credit Private Pool (the “Fund”), Series F, outperformed its benchmark, the FTSE Canada Universe Bond Index in Q4 2023, due to credit positioning. Within public credit, returns on the Fund’s U.S. corporate bonds led the way on performance in Q4 2023 as U.S. credit spreads outperformed and the Fund’s associated hedges also outperformed. U.S. corporate credit spreads were 22 basis points tighter in Q4 2023 versus 15 basis points of tightening in Canadian corporate credit. The Fund’s U.S. corporate bond hedges further supported active returns mostly due to long Canadian swap spreads moving 15 bps tighter in Q4 2023. Rates positioning was relatively neutral to active returns during the quarter. The Fund’s long-term strategic holding in the SLC Management Short Term Private Fixed Income Plus Fund detracted from active returns as credit spread compression in private debt lagged the credit spread rally in the public corporate bond markets.
Early in Q4 2023, the Fund’s corporate bond trades focused on rolling back from long-dated credit into the 10-year term to take advantage of the very flat credit curves in both the U.S. and Canada. New issue concessions in corporate bonds were limited so they were mostly involved in secondary trading during Q4 2023.