Two Steps Forward, One Step Back

Rebounding global economies, increased demand for commodities and attractive valuations in Canada’s equity market are setting the stage for a strong second half of 2021.

Tom O’Gorman

Tom O’Gorman Director of Fixed Income, Franklin Bissett Investment Management

Darcy Briggs SVP,

Darcy Briggs SVP, Portfolio Manager, Franklin Bissett Investment Management

It was in the second quarter of last year that everything halted, markets swooned and economic data hit dramatic lows as the COVID-19 pandemic spread to virtually every corner of the globe.

Since the initial drawdown and reopening, global economic activity has remained resilient, supported by unprecedented amounts of fiscal and monetary support as economies have adapted to the stop-and-go nature of this pandemic. Countries with higher vaccination rates are having success in controlling the spread of the virus. Fifteen months after the pandemic shut down the global economy, many countries are getting back to work.

Canada is one of them. As the country wrestles down its third wave of virus infections, a stepped-up nationwide vaccine rollout and renewed international demand for Canada’s natural resources—crops, energy and metals—provide a promising dynamic for the second half of 2021.

How high can the loonie fly?

So far this year, the Canadian dollar has been the best-performing currency in the G10, rising 5.4% against the U.S. dollar year to date (YTD). Elevated commodity prices and other reflationary economic elements are helping to drive strength in both the currency and longer-term interest rates. One key element in the recent strength of the Canadian dollar is a perceived hawkish tilt by the Bank of Canada (BoC). As interest rates and currency move on relative valuations, the perception of the Bank of Canada could move early in normalizing the monetary policy rate helped lift the loonie for most of this year. The currency’s strength has already tightened financial conditions and moved valuation into fair territory. Further strength could potentially crowd out other key sectors placed at a disadvantage by a stronger Canadian dollar, which concern the BoC.

Supply, demand and the inflation equation

Canadians wondering what lies ahead over the next several months need look no further than south of the border to the United States. Since the Biden administration announced in January that it would focus intensively on vaccination, the rollout has been faster than anticipated. Fiscal stimulus has also substantially exceeded expectations, providing the means to accelerate household consumption and creating excess demand conditions.

Supply chain disruptions since the start of the pandemic have reduced inventory and new production, restricting supply. While the composition of purchases will shift to include more services as the economy reopens, the combination of these factors has created conditions in which activity and inflation could both be stronger than expected over the near term. Over the past 12 months, the U.S. Consumer Price Index (CPI) has risen 5.0% year-over-year (y/y) to end of May, partly due to these factors and partly to lapping very low data from 2021.

Inflation, yes. Sustained? Maybe not

Inflation also rose in Canada to 3.6% y/y in May from 3.4% y/y in April, mostly due to the statistical comparison to last year, when prices sank during pandemic shutdowns. Taking into account the lower expected base effect, while elevated, Canadian inflation data reflect the dynamic of the stop-and-start nature of the pandemic.

Inflation expectations have moved to the highest levels since the period immediately following the Global Financial Crisis (GFC). While a marked increase in inflation has largely been discounted, durability of the recovery in inflation remains uncertain in terms of the ability to pass along higher costs. Factors needed for durable inflation remain soft as slack remains in both capacity and labour markets. In addition, disinflationary secular factors, demographics, debt, disruptive technology and globalization remain a counterweight to near-term cyclical inflation.

Uncertainties remain elevated. From a data perspective, we expected a messy, low-visibility second quarter given all the distortions from lapping the period where everyone was sent home. There is a wide dispersion of possible outcomes for the balance of 2021, but we expect that increased visibility on the future path of economy activity and the markets will emerge as we leave the point of maximum data distortions and see further positive progress on ending the pandemic globally. The extreme nature of the backup is largely predicated on the prospect of substantial fiscal stimulus. With the next U.S. fiscal stimulus packaged bogged down in politics, we would not be surprised if rates drifted lower as the year progresses. Realistically, the path ahead will remain a little messy.

Steepening yield curves reflect recovery

During the first three months of the year, the BoC’s extraordinarily accommodative monetary policy provided little resistance against an upward rise in yields; however, the second quarter saw little movement, and even a slight flattening of the curve as expectations for central bank policy were recalibrated. Sovereign markets have re-marked growth and inflation expectations, lifting long yields and steepening the yield curve. Canadian long rates have underperformed U.S. rates, largely due to market expectations that the BoC would lead the U.S. Federal Reserve (Fed) in tightening monetary policy, which we believe is misplaced.

We expect Canadian rates will outperform U.S. long rates in the second half of the year. There is growing evidence that key pre-existing economic imbalances in Canada (household debt is one example) have worsened during the pandemic, suggesting that the Canadian recovery will lag that of the United States.

Corporate credit worth watching

Looking at Canadian corporate credit, where stay-at-home sectors like investment-grade (IG) communications and IG media really outperformed during the lockdown, a rotation to “reopening” bonds, such as IG commodity and IG energy issuers, is underway.

For example, factoring pre-pandemic conditions and the multi-year transition to other energy sources into our analysis, we remain constructive on debt investments of Canadian energy companies over our investment horizon. There is not a lot of associated exploration or development risk. Costs are fixed, and as expected demand ramps up, there will be increased incremental cash flow, making these bonds more attractive from a credit standpoint.

We are also finding attractive opportunities in high yield (HY) bonds, recently introduced limited recourse capital notes (LRCN), as well as the preferred share and global loan markets. It is worth noting that the latter three have defensive properties in an environment of higher-trending interest rates.

Canadian IG vs HY Bonds - Option Adjusted Speed (bps)March 2, 2020 - June 18, 2021

Source: S&P Global, Franklin Templeton: For the period from March 2, 2020 – June 18, 2021

Mind the bumps

While the early months of 2021 in Canada were marred by vaccine supply disruptions and a massive third wave of infections that triggered additional economic restrictions in most provinces, conditions for the remainder of the year appear more favourable. Canadian vaccine supply and take-up appear to be making up for lost time, and the federal government’s goal of having 70% of the populace fully vaccinated by the end of summer is looking more attainable.

We expect fiscal and monetary policies will remain very accommodative/expansionary over the remainder of the year in support of economic growth. On nearly every economic metric, Canadian data is much softer than U.S. figures, yet markets are pricing the BoC leading the Fed in rate hikes.

We also expect inflation is near a peak, given very easy base effects, and will likely trend slightly lower later in the year. We are less worried about a sustained rise in inflation and rates longer term in view of the secular deflationary forces.

Still constructive on credit

We remain constructive on credit longer term considering return expectations across all fixed income sectors. We expect corporates will continue to outperform given a strong fundamental and technical backdrop, although richer valuations continue to suggest a more modest expected return profile for corporate debt going forward.

In recent months, we have positioned our portfolios slightly defensively (slightly reducing duration and convexity of the bonds in our portfolios). Where applicable, we have added high yield, bank loans and other corporates as we expect better risk-adjusted returns from these sectors. We will look to capitalize on opportunities as they arise.

Reasons for both optimism―and caution

First-quarter bond market returns are unlikely to reflect full-year returns and the Canadian bond market will recover some of the lost ground; markets can overshoot from time to time. Bond yields are within fair value given the current economic backdrop. With fiscal stimulus gridlocked in U.S. politics and the U.S. central bank now attuned to the current inflation environment, we don’t see a repeat of first-quarter events in fixed income markets.

Data will drive fixed income markets in the months ahead. Since the pandemic has not yet ended, investors should expect some volatility as the year progresses. When these bouts of turbulence occur, they provide opportunities for active fixed income managers.