AGF Fixed Income Plus

Positioning and outlook following the recent Bank of Canada rate hike

Bank of canada rate hike

The Bank of Canada hiked policy rates on July 12th, its first increase in almost seven years. The central bank believes that the cyclical rebound in the economy, which began during the latter part of 2015, was mature enough to justify the move. Further, the central bank asserts that the economy has already completed the necessary adjustments to the oil price shock that began in mid-2014 and that the two emergency rate cuts in 2015 were no longer required.

 

We anticipated a rise in bond yields following the lows of July 2016, as we believed that a global economic recovery was underway, supported by stronger economic data and rising inflationary pressures. The Bank of Canada had held rates steady for an extended period, waiting for export activity, business investment and economic slack to improve. While exports have not rebounded to the extent desired, economic slack has largely been eliminated due to strong consumption. As such, the Bank of Canada viewed the current state of the economy as being incongruent with the emergency level of accommodation. The swift turnaround in central bank rhetoric starting in mid-June merely reflected an economy that was outperforming its peers. Thus, the Bank of Canada hiked rates as GDP growth has averaged 3.5% over the last three quarters, compared to 0.9% in 2015 and 1.5% in 2016.

Figure 1. Accelerating economic growth supported a rise in the policy rate and government bond yields

 

 

Source: Bloomberg. Economic growth monthly, annualized, to April 30, 2017. Bond yields and overnight rate to July 17, 2017.

 

outlook – more hikes on the horizon

With the recent change in policy stance, we anticipate that the central bank’s path of policy normalization may extend further than merely removing the two emergency cuts that it implemented in 2015. Strong consumption has led the central bank to upgrade its growth forecast for 2017 and 2018. Also supporting growth prospects is our belief that oil prices will rise modestly later this year, supported by a supply/demand balance that should move closer to equilibrium as global growth trends improve and supply wanes. The closing output gap could also lead to higher inflation. While current inflation is below the central bank’s 2% target level, Governor Poloz has emphasized the need to target future inflation, recognizing that current policy decisions will only take “full effect in 18 to 24 months”[1]. Thus, considering all these factors, we believe that current policy rates of 0.75% are too low and will need to move higher.

 

canadian dollar

The Canadian dollar has appreciated significantly since the beginning of May and moved materially higher alongside the significant shift in the central bank’s policy stance. In the near term, we believe that the rally in the Canadian dollar may be overdone, but it still has room to strengthen further given economic strength, central bank hawkishness, and still bearish (albeit waning) sentiment. In the medium to long term, however, with markets fully pricing in another hike in the next six months and potentially more in 2018, a further material rise in the Canadian dollar will need support from either stronger economic growth or higher oil prices. While we are comfortable with economic and Canadian dollar strength over the next 6-12 months, 2018 will be more challenging. The housing market remains vulnerable and has represented a key driver of economic growth in recent years. Price and sales activity has cooled in key markets, and any resumption of the strong trends that existed prior to the Ontario government’s legislation in April will likely prove unsustainable. In our view, while further rate hikes can continue to cool the Canadian housing market, the Bank of Canada will be unable to embark on a protracted or material rate hiking cycle, as the economy would become more vulnerable to a recession.

 

agf fixed income plus

Positioning with respect to the Canadian economic environment and monetary policy

As we anticipated rising bond yields, we have maintained a somewhat short duration stance relative to the benchmark (currently 0.4 years shorter than the duration of the FTSE TMX Canada Universe Index, representing 94% of benchmark duration) over the past year. Also, we employ active currency management within the portfolio, primarily to mitigate risk and secondarily to potentially add value for unitholders. As such, we increased U.S. dollar hedges to the mid-80% range earlier this year, for net U.S. dollar exposure in the portfolio of slightly over 2%, as we had concerns that the market was underestimating Canadian dollar strength. Thus, our decisions to maintain a lower duration than benchmark and minimal U.S. dollar exposure both benefited performance.

Nevertheless, we have not reduced duration more aggressively at this juncture as we believe that we remain secularly in a low growth, low inflation, and low yield environment. Further, we are currently in the mature phase of the current economic cycle. As such, while this year is showing improvement in year over year growth rates in regions like Europe, Canada and China, sustaining such momentum becomes more challenging next year. Furthermore, tightening will eventually become a headwind, especially given the high debt levels within the economy. These factors should ultimately lead to a renewed bout of weakness in the Canadian dollar. Consequently, while we are maintaining low U.S. dollar exposure on a net basis, we anticipate increasing our U.S. dollar position in the medium term.

 

 

 

‘Plus’ component of AGF Fixed Income Plus helping performance

Given higher valuations for high yield and convertible bonds and the fact that we are in the later stage of the capital market cycle, we have modestly reduced our ‘Plus’ exposure to approximately 11%, from approximately 13% earlier in the year. However, we are mindful that the ‘Plus’ component has added value this year and over the long term, and has further mitigated the impact of rising bond yields since the middle of July 2016, when yields bottomed. As such, we continue to opportunistically seek investments with strong potential to add value while not exposing the portfolio to undue risk.

 

For more information, speak with your AGF relationship manager or visit AGF.com/Institutional.

 

 

 

 

 

 

The commentaries contained herein are provided as a general source of information based on information available as of July 18, 2017 and should not be considered as personal investment advice or an offer or solicitation to buy and / or sell securities. Every effort has been made to ensure accuracy in these commentaries at the time of publication, however accuracy cannot be guaranteed. Market conditions may change and the manager accepts no responsibility for individual investment decisions arising from the use or reliance on the information contained herein.

 

AGF Investments is a group of wholly owned subsidiaries of AGF Management Limited, a Canadian reporting issuer. The subsidiaries included in AGF Investments are AGF Investments Inc. (AGFI), AGF Investments America Inc. (AGFA), Highstreet Asset Management Inc. (Highstreet), AGF Asset Management (Asia) Limited (AGF AM Asia) and AGF International Advisors Company Limited (AGFIA).

 

AGFA is a registered advisor in the U.S. AGFI and Highstreet are registered as portfolio managers across Canadian securities commissions. AGFIA is regulated by the Central Bank of Ireland and registered with the Australian Securities & Investments Commission. AGF AM Asia is registered as a portfolio manager in Singapore. The subsidiaries that form AGF Investments manage a variety of mandates comprised of equity, fixed income and balanced assets.

 

This document is for use by accredited investors only.

 

Published Date: July 28, 2017

 

[1] Bank of Canada, July 12, 2017