Mackenzie Fixed Income Team
Outlook & Positioning
- The first half of 2018 presented investors with potential reasons to be either optimistic or uncertain about markets looking ahead. On the one hand, the domestic growth story in the US seems to be relatively strong, braced by the tax cuts, fiscal, and deregulation agenda put in place by the Trump administration. On the other hand, the same administration has engaged the world economy in an increasingly hostile trade skirmish. Is this an effort to win small concessions that Republicans can take to the mid-term polls to win votes in November, or is it just the beginning of a movement toward a full-blown trade war?
- On the monetary policy front, the newly minted Chairman of the FOMC, Jerome Powell, having inherited the gradual rate hike agenda from Janet Yellen, has tweaked forward guidance on interest rates in a slightly more hawkish direction, while some Fed governors have increased their Fed Funds rate projections ("dot-plot") over the next two years. The continuing strength of the US labor data and in the economy overall, along with a movement of the inflation data roughly back to the 2% target have certainly given Powell the incentives to be less accommodative with monetary policy. The question of how far the Fed Funds rate can or needs to rise in this cycle is still up for debate, as the bond market's expectations for future inflation rates remain close to 2%, and the US yield curve has continued to flatten this year.
- Perhaps pressured by both the rising US policy rate and yield curve, and the Trump trade tariffs, emerging markets began to react during the second quarter with some currencies weakening against the US Dollar. The increased potential for a weakening in their trade balances along with a higher cost of refinancing their growing US dollar debts, has likely caused some investors to reconsider the risk premiums embedded in recent valuations, after what had been a strong run of performance. Emerging market debt is one area where returns have sagged during 2018.
- The Bank of Canada appears to be on an even more gradual rate-hike path than the Fed. With the early July rate hike in-the-bag, the mixture of uncertain trade war impacts and domestic housing market softening will likely have Poloz lagging the Fed by one hike through the next two quarters.
- The ECB has signaled that QE-tapering will lead to a potential rate hike agenda in the summer of 2019. This coincides closely to the expected handover of the ECB Presidency from Mario Draghi to a yet-to-be-determined successor. This uncertainty and potential for ECB tightening, along with expectations of perhaps as many as four hikes to come from the Fed by then, and possibly three from the Bank of Canada, could be a significant test of the interest rate sensitivity of the global economy.
- Only select few areas have seen deleveraging this cycle, such as US households, and developed markets' banking sectors, while many others have increased their debts. Canadian households, most developed and emerging market sovereign issuers, and more recently, investment grade non-financial corporations are among those where debt continues to rise. The cumulative effects of higher rates will eventually feed through into higher costs for new borrowings and debt refinancing, pressuring profit margins and previous valuation assumptions.
- While some evidence of this may be beginning for emerging market debt, strong US corporate profitability and a low amount of debt to refinance this year have allowed valuations in high yield bonds and floating rate loans to remain on the richer side. The fundamental picture for North American non-investment grade credit remains reasonably good overall, although some later-cycle behaviors are visible beneath the surface. Merger and acquisition activity has picked up, and so has the amount of leverage being used in these transactions. The test for these deals usually comes not at the closing, but later, when business growth and synergy assumptions made during the valuation fall short of expectation, and for some, the larger debt burden becomes too costly to bear.
- All of this means that we expect the rewards for taking a risk in any one area of the market are less certain today, and likely to be interrupted by macro risks. Being increasingly selective within corporate credit sectors, increasing portfolio diversification, using active hedging strategies around macro risks, and remaining nimble in repositioning portfolios are examples of our approach as we head into the second half of the year.