Economic & Market Review - February 2015

by Gavin Graham, Chief Strategy Officer February 08, 2015
Notice: This newsletter is intended as a general financial market outlook, and should not be relied on as investment advice.
The recent interest rate cut in January by Bank of Canada Governor Stephen Poloz, reducing rates by 0.25% to 0.75%, caught many investors and commentators by surprise. Admittedly, the Canadian economy is experiencing slower growth, as Gross Domestic Product (GDP) fell 0.2% in November 2014, meaning Canada’s GDP grew by only 1.9% in the twelve months ended 30th November. This compares unfavourably with economists’ forecasts of 2.1% for the period and with the US, which grew 2.6% in the fourth quarter of 2014, and by 2.4% for the year as a whole.

The reason for the slower growth in Canada was, unsurprisingly, the sharp fall in the price of commodities, especially crude oil, which fell by more than 50% between June 2014 and January 2015, with the price per barrel of the benchmark West Texas Intermediate (WTI) grade falling to U$44.55 on January 29th, the lowest price since March 2009. The Bank’s statement on January 21st stated “This decision is in response to the recent sharp drop in oil prices, which will be negative for growth and…inflation in Canada.” With much of western Canada’s economy dependent upon the oil and gas industry, especially in Alberta and Saskatchewan, the halving of the oil price has already started to have an effect upon investment and employment.

Mr Poloz and the Bank of Canada evidently felt that the slowdown in GDP growth was likely to continue for a while, due to the effects of lower resource prices, and said “the Bank is projecting that real GDP growth will slow to around 1.5% in the first half of 2015”. It did go on to say that the effect of lower oil prices would “be mitigated by a stronger US economy, the weaker Canadian dollar and the Bank’s monetary policy response (i.e. the interest rate cut).” The Bank expects Canada’s GDP to grow 2.1% for all of 2015 and 2.4% in 2015.

The Canadian dollar fell by 8% against the US dollar in 2014 and has weakened another 7% in January, with the announcement of the fall in Canada’s November GDP seeing the currency hit U$0.787=C$1. Since its high of U$0.935 reached at the end of June last year, the loonie has fallen 15 cents, or almost 18%. This has the same effect as an interest rate increase, tightening monetary conditions as it takes more Canadian currency to buy the same amount of US goods, so there are grounds for Mr Poloz’s actions in reducing interest rates. Admittedly, it also contributes to higher inflation, but as the fall in the oil price has been so large, as noted by the Bank in its rate cut statement, it will offset the temporary rise in imported inflation. Furthermore, the lower currency makes Canadian goods more competitive, which will boost exports outside of the energy and resource sectors.

The result of this somewhat unexpected action by the central bank on the bond market has been very notable. The yield on the benchmark 10 year Government of Canada bond has fallen to record lows of 1.27% at the end of January, down almost half a percent (0.47%) in a month and by over one percent (1.06%) in the last year. The same phenomenon can be observed in other developed countries bond markets, where the fear of deflation (price declines) has driven the 10 year yield to 1.67%, close to the 60 year low reached in 2012 and also down almost 1% over the last year.

Meanwhile, in Europe, German 10 year Bunds yield a pitiful 0.31%, an all-time low since the founding of post-war Germany in 1949, and Japanese bonds yield a similarly low 0.28%. Switzerland, which was forced to abandon its 3 year old policy of pegging the Swiss Franc to the Euro at E1.20=SwF1 in mid January, leading to the Franc rising 20% in one day, actually has negative interest rates of -0.75% on cash and 10 year bond yields of -0.11%, in an attempt to dissuade investors seeking a safe haven from driving up the Franc even more. With the exception of Japan, which has endured 20 years of deflation, and whose bond yields were already below 1%, every other major bond market has experienced falls of at least 1% in the yield on their 10 year bonds.

At INTEGRIS Pension Management Corp., we have commented on the phenomenon of very low long-term bond yields several times over the last two years. Our view has been that it is very difficult to achieve a reasonable real return after inflation when interest rates and bond yields are so low. While inflation has not been a major concern over the past few years, and should not be an issue this year with the fall in oil prices, even an inflation rate of 2%, the Bank of Canada’s target, will mean that buyers of 10 year bonds at present interest rates will suffer losses in real terms with yields as low as they are at present.

Investors with a long term horizon, such as pension fund trustees, have to keep several basic principles in mind. Firstly, it is always important to have a portfolio that is diversified between several different asset classes that are not correlated with each other, such as bonds, cash and equities, to ensure that the fund is not over exposed to just one asset. Secondly, whenever one asset class has performed very strongly over the most recent period, such as bonds at the moment or equities in the mid-2000s and the late 1990s, it is prudent to periodically rebalance the portfolio back to its original asset allocation. This is perhaps the most difficult discipline, as it means selling some of what has performed well to buy what has not performed, which is contrary to our inbuilt behavioural biases.

Perhaps the most important principle to bear in mind is that the return that can be expected from a portfolio is the sum of the income received and any growth in capital that may occur. For fixed income investments like bonds, the only return that an investor receives is the coupon (interest) on the bond and nominal amount of the bond when it matures. With yields so low, and bonds selling at premiums to their maturity value, the total return that will be received from buying bonds at their present levels will be very low, if not negative in nominal terms, let alone real (after inflation) terms. As we have suggested before, pension investors should consider other types of bonds than developed countries government bonds when constructing portfolios, such as investment grade corporate bonds and emerging market sovereign bonds denominated in US dollars. With higher yields, sometimes two or three per cent higher than government bonds, and with better fundamentals such as stronger balance sheets and better demographics, investors should not be deterred from having higher weightings in corporate bonds or emerging markets than the weightings in bond indices.

All figures are from Bloomberg and the Globe and Mail as at February 2, 2015