Market review
The first quarter of 2025 (Q1) was an interesting one for both interest rates and credit. Inflation, which had been falling in Canada, showed some potential for reversing, increasing from 1.9% in January to 2.6% in February as the GST holiday ended. However, inflation still remained within the Bank of Canada's (BoC's) preferred range of 1%-3%. This left the BoC some room to lower rates by 50 basis points (bps) during the quarter to counteract subpar Canadian economic growth and the potential damage from Canada’s largest trading partner, the United States, possibly implementing trade sanctions on Canada.
With the BoC leading the way, the Canadian yield curve steepened out as 2-year Canada bonds fell 42 bps while 30-year Canada bonds were only 10 bps lower. In contrast to the U.S. credit curve steepening, the Canadian credit curve flattened during Q1. In overall credit markets, the U.S. and Canada all corporate Bloomberg indices were 14 bps wider. Long credit in Canada had a unique quarter as long Canadian corporates were only 9 bps wider compared to U.S. long corporates at 18 bps wider. Not only was there very low issuance of new long Canadian corporates, but the upsizing of one corporation's long bond cash tender offer (and the potential for more corporate tender offers) left investors scrambling at the end of the quarter to find new long bonds to replace them. While corporate issuance in Canada was a solid $38 billion in the quarter, investor flows into Canadian fixed income and the return of more reasonable new issue concessions helped to grease the wheels to absorb the supply.
With both provincial and corporate credit spreads moving wider in Q1, performance of credit was really driven by quality. Provincials outperformed high-quality corporates in most parts of the curve except in the longest maturities, while lower quality corporate credit performed the worst in all terms. Higher beta credits like bank subordinated debt and real estate investment trusts were noteworthy laggards due to the risk-off tone and notable bankruptcy of a major national retailer. Automotive bonds, a sector that became a focus of trade policy discussions, were the notable underperformer in the quarter.
The good news is that Canada and Mexico have received a reprieve on goods that comply with the United States-Mexico-Canada Agreement (USMCA). However, Canada still faces tariffs on autos, steel, aluminum and on non-compliant-with-USMCA goods. This amounts to a 6% - 7% effective tariff rate on U.S. imports. Canada has retaliated in a targeted way but has left the door open for negotiations.
Growth likely to take a hit
The U.S. effective tariff rate is expected to hit 18%, if all announced tariffs hold and there is some reasonable substitution. These levels far exceed the initial estimates of most economists.
While importers initially pay the tariff, it typically gets passed along to the consumer. And it ends up being a sales tax that is more regressive on lower income households.
As a result, global trade and growth is expected to take a hit this year. Some early forecasters are already penciling in a technical recession - two consecutive quarters of GDP contraction - for both the U.S. and Canada. Other countries are also likely to be dragged down as consumers across the world are paying more for a shrinking basket of goods.
While backward looking, U.S. economic data still look good. But forward looking surveys of consumers and businesses show pessimism. Gloomy surveys don’t always result in a pullback, but consumers seem well aware that tariffs typically push prices higher.
Stagflation risks
If tariffs persist and growth dips, central banks may end up in a tough spot if inflation rises. This lower growth and higher inflation mix, that economists call stagflation, is very challenging for central banks who rely primarily on rate shifts to calibrate the economy.
If growth drops, the typical reaction is to cut rates to spark a recovery. However, if inflation is already high, it limits how aggressive central banks can be, as they need to closely calibrate against the risk of stoking inflation - not an easy balancing act.
While Canada has room to cut rates, it also has the capacity to employ fiscal stimulus and help households and businesses navigate some of the shock. This is a big advantage over the U.S., which has a substantial fiscal deficit and therefore needs to cut its spending to bring it under control.
Market volatility is up
Global equity markets have pulled back and credit spreads have widened as investors fear company profits could get pinched. U.S. equity indices in particular have been hit hard. What is challenging about this risk episode is that it is not the result of a turn in the business cycle, but rather from an abrupt shift in U.S. trade policy. Therefore, constructive tariff negotiations and adjustments could help reset and avoid a more material setback.
Fund review
Over the quarter, the Sun Life Core Advantage Credit Private Pool (the “Fund”), Series F, underperformed its benchmark, the FTSE Canada Universe Bond Index.
According to the Bloomberg indices, both Canadian and U.S. corporate spreads widened 13 bps in Q1. The Fund's active return from credit positioning was slightly overshadowed by its curve and duration positioning which detracted from relative performance.
The Fund's cross currency hedges for its U.S. bond positions helped offset the U.S. spread widening, as associated hedges contributed to performance mostly due U.S. long swap spreads widening. Both the private fixed income funds outperformed their benchmarks which contributed to relative performance.
Over Q1, our sub-advisor, SLC Management’s (SLC’s) portfolio management team increased federal government bond and SLC Management Private Fixed Income Plus Fund weights and reduced public corporate bonds. SLC also reduced the Fund’s U.S. dollar holdings both in treasuries and in corporate bonds. In corporates, SLC participated in new issues from Bank of Montreal and a CMBS deal while taking profit in Magna and TSX Group bonds.
