Market Review
The significant increase in yields was the primary story of the Canadian bond market in the third quarter (Q3) of 2023. The pickup in both nominal and real rates that defined the second quarter, gained momentum in Q3. 10-year Canadian bonds yields that rose a massive 76 basis points (bps) in Q3 even eclipsed the 73 bps rise in 10-year U.S. Treasury yields. This rise in yields led the entire Canadian yield curve upward.
After holding interest rates at 4.5% until May 2023, the Bank of Canada (BoC) raised rates in June and July for a total of 50 bps. This showed that the BoC was serious about fighting inflation. The BoC noted that both demand and inflation were more persistent than it had expected. The BoC also decided to continue its passive quantitative tightening strategy by allowing maturing bonds to roll off its balance sheet. This along with the growth in the federal government’s deficit spending put pressure on Canadian bond yields.
Q3 credit spreads tightened by 3bps on the Bloomberg Canada Aggregate Corporate Index, closely matching that of its U.S. counterpart. Canadian bond markets finished the quarter with a monthly record for corporate bond issuance in September, while year-to-date supply until Q3 trailed 2022 levels. In Q3, financials sector performed the best and infrastructure sector performed the worst in terms of returns.
Market Outlook
Tepid economic growth in China has been a negative surprise for the global economy so far this year. Consumers remained cautious in China as policymakers were reluctant to stimulate the economy and focussed on containing the risks in the country’s real estate market. Europe’s economy slowed quicker than expected as high consumer prices took a toll and a slowdown in Germany affected growth. However, trade growth in South Korea sent encouraging signals as technology exports started to improve.
Geopolitical risk remains high
Beyond Ukraine, the tensions between U.S. and China came to the fore. As the U.S. sought to contain China’s technological progress, it banned China’s access to advanced U.S. chips and encouraged allies to follow suit. The global trading system is reordering around a “China plus One” policy. This strategy encourages large manufacturing and retail companies to lessen their supply-chain dependence on China and diversify their supply base and network by investing in countries outside China. The U.S. and other countries that relied on China for supply chains are now actively diversifying by expanding in Mexico, Vietnam, India, Indonesia and the Philippines.
Global inflation is coming down
As inflation receded, central banks in most developed economies are close to peak interest rates. But they have signaled that they will keep rates higher for longer. This probably means that higher interest rates will persist for another 8-12 months. Most central banks want to see ample evidence that inflation is falling to target levels rather than prematurely cutting rates that could stoke inflation again.
U.S. inflation continues to improve. While goods inflation has dropped significantly, services inflation continues to be high. However, critical drivers of services inflation, such as wages and rents, are normalizing.
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.
Where do we go from here?
While most major central banks appear close to peak rates, they will be cautious on when to cut rates. Our sub-advisor, SLC Management (“SLC”), thinks central banks need to avoid cutting interest rates prematurely to prevent another round of inflation.
The challenge for central banks is that the cooling effects of higher rates works through the economy with a lag that is difficult to forecast. The U.S. Federal Reserve’s (the “Fed”) forecasts two rate cuts next year, according to its recent Summary of Economic Projections.
While the market thinks rates will be lower than the Fed’s projections, the difference in views has been shrinking. And this is helping affirm the Fed’s credibility. Markets ultimately believe the Fed’s decisions will be pragmatic and data dependent.
Fund Review
Sun Life Core Advantage Credit Private Pool (the “Fund”), Series F, outperformed its benchmark, the FTSE Canada Universe Bond Index, this quarter, mostly as a result of credit positioning. Within public credit, the Fund’s Canadian dollar and U.S. dollar holdings each contributed to relative performance. Among Canadian dollar holdings, the Fund benefitted from being underweight provincial bonds and overweight corporates relative to the benchmark. Provincial credit spreads widened out to close the quarter, even while corporate spreads remained tight. Long-dated U.S. corporate credit spreads continued to tighten this quarter, outperforming long-dated Canadian corporate credit spreads. SLC took advantage of this by selling U.S. long-dated credit, including insurer Marsh & McLennan and utility Public Service Company of Colorado.
The Fund’s long-term strategic holding in SLC Management Short Term Private Fixed Income Plus Fund continued to benefit performance this quarter (as it has for most of 2023). It also helped outperform its short corporate debt benchmark (FTSE Canada Short Term Corporate Bond Index). The outperformance came mostly from the positive carry but was also helped by the credit spread compression of private debt relative to public corporate credit spreads.
