At this week’s conference call, I remarked how this was the second-year anniversary of when Ally and I started the regular calls at the start of the pandemic (details for the playback can be found at the end of the commentary). While the past two years have been a blur for many, it is important to realize just how quickly events turned and how risks to one segment of the market, like equities, have shifted to the other camp – that being bonds. Considering that the majority of investors in Canada are probably in some form of “balanced” portfolio, the developments of the last several weeks can be concerning. Let’s have a look at this changed landscape and see how best to navigate these waters without necessarily making wholesale changes to our asset allocation strategies.

 

In terms of the tectonic shift in the economic and financial situation, consider that back in March 2020 we watched inflation tumble to negative levels, along with oil prices, and were stunned to see unemployment rates soar. Take this week’s US jobless claims report. It was reported that initial claims last week fell to 187,000 – the lowest since September 1969 (182,000).  At the peak, at the start of April 2020, initial claims were above 6 million people.

 

 

Some have commented that tightness of the labour market is even more profound when we adjust the claims figures for population. In the above chart, I have taken initial claims as a percentage of the US population and last week’s number was 0.06%. Indeed, this number is well below the ratio seen in 1969, although it is really only the lowest since, guess when?  Yes, right before the pandemic hit.  The previous record low for this ratio was back in April 2019. If you could possibly imagine, just for a moment, that the pandemic didn’t happen then what we are seeing today is simply a continuation of a tightening in the US labour market from after the financial crisis of 2008-09.

 

This snap back to reality is not quite echoed on the inflation front, given that inflation reality before the pandemic was, well, virtually non-existent. After peaking at 4% two years after the 2009 recession, US consumer price inflation fell to zero during the global economic slowdown in 2015. A pick-up in economic growth took it back to almost 3% in 2018, then another fade as Trump’s tariff war created another economic jolt. Today, the rate is almost double the high it reached in 2011 as commodity price pressures meet supply constraints elsewhere and a labour market that is, so far, providing support for passing on price increases.

 

 

This dramatic reversal in labour force and inflation has underscored the shift in market expectations of what central banks will have to do to confront this situation. Fed Chairman Powell commented earlier this week that the Fed might have to raise rates by half a percent and other Fed officials followed with remarks focusing on how the central bank needs to get the fed funds overnight target rate back to “neutral” sooner than later. There is no hard estimate of what neutral is, but consensus is that it is close to 2%. That is another 1-1/2 percentage points from where we are today and would imply either a quarter point move at the remaining six meetings this year, or an even faster push via larger moves into the summer. The December fed funds contract implies a 100% probability of a 2% rate so this return to normal is broadly anticipated. The issue is whether this is just the first phase of tightening and that the Fed, and other central banks, have to shift to a rate regime that is net restrictive and not neutral.

 

The impact on the bond market from this turnaround in developments has been profound. Let’s restrict the analysis to the Canadian market for now.  An ETF that tracks the aggregate Canadian government market (the iShares Canadian Government Bond Index – XGB) is down 8% since the start of the year, for a total return (after reinvestment of dividends) of minus 7.6%. A similar ETF that tracks the Canadian Corporate Bond index, is down 7.2% over the same period, but with a higher yield than government bonds, the total return on that index is minus 6.7%.

 

Excluding the NASDAQ and some European equity indices, these numbers are worse than what we have seen in stocks – hence, why they are profound.  Compared to the 3.3% rise in the TSX since the start of the year, they are really profound. In other words, for a balanced portfolio, there doesn’t seem to have been much protection against what the first quarter has thrown at us. If all we did was track the Canadian government or corporate bond indices, this would be true, although I would still stand by the view that over the long-term, bonds do provide a cushioning against volatility. The question is whether we can maintain a balanced portfolio construction, that is consistent with our risk tolerance, but not get hit to the same extremes that the bond market is going through as monetary policy tightens? The answer is that you can, but it requires a layering of fixed income investments that are not as correlated to the pure interest rate moves taking place.

 

As our clients know, Ally and I have been doing this for a while and over the past year we have shifted the components of the fixed income portfolio to be less correlated with government debt and even investment grade bonds. For example, we have overweighted floating rate debt and, while that segment of our model is down about 2% in price, the total return since the beginning of the year is minus 1.3% - much better than what both government and corporate aggregates have done. We have also used a very tactical and value-oriented corporate bond pool, that has confined losses to less than 3%. Losses of any magnitude are never a good thing, but staying ahead of the broader market is a way of preserving capital for when volatility subsides.  As I have always said, it’s not just about growing capital, but having the capital to grow.

 

There is another layer to the fixed income portfolio that can also aid in preserving capital and improving return through a monetary policy tightening environment and that is in the use of alternative investment approaches where we can try to neutralize the effect of rising interest rates. Ally and I are doing our due diligence on those approaches and will utilize them if the tightening cycle looks to be prolonged, especially if we can do this without altering the low to medium risk profile of the fixed income portfolio.

 

The final point I will make is that, as much as this fixed income environment is different than what we have seen for many years, the tactical measures we take should not be viewed as long-term. Even on the equity side of the ledger, we often don’t look at things as necessarily being long-term.  At some point, interest rates will reach a level that cause economic activity to slow down. It is highly probable that economies, including Canada’s, could fall into recession. Since economic cycles are still a reality, this isn’t a huge forecast since it is missing the “when” part of it. Still, at some point a turn down will occur and usually this is met with monetary easing (cutting rates). Those government bonds that have dealt such rotten cards so far this year, typically rally with rates falling. When this is likely to happen is when the fixed income portfolio gets re-adjusted again. Till then, it’s about using what we can to keep from suffering what the indices are doing.

 

On behalf of the Pyle Group, have a wonderful weekend.   

Andrew

 

Conference Call Playback 

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Expiry date: 22-Apr-2022 23:59

 

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These are the personal opinions of Andrew Pyle and may not necessarily reflect those of CIBC World Markets Inc.