Manager commentary - December 31, 2018

Despite an exceptional rise in U.S. business profits, the decision by the U.S. Federal Reserve (Fed) to continue normalizing its monetary policy and the escalation of U.S.‐China trade tensions have created a highly volatile environment on Wall Street. This resulted in the S&P 500 Index posting a drop of nearly 15% in the fourth quarter of 2018, its worst quarterly performance in a decade. The last month of the year was particularly painful, recording a drop of 9.2% – the worst December since the 1930s.

The most important factor affecting global financial markets over the year was probably the Fed’s monetary policy tightening. The correction in the fourth quarter is a reminder of the impact that tightening liquidity conditions in financial markets can have on portfolio returns.

When the Fed raises its key rate, two phenomena are usually observed: 1) increased volatility in the markets and 2) stock market value, measured by the ratio of price to profit, contracts; that is, investors are willing to pay less to invest in markets despite an increase in corporate profits.

Further adding to uncertainty, trade tensions created by President Trump were omnipresent throughout the year. The renegotiation of the North American Free Trade Agreement (NAFTA) and, more recently, U.S.-China negotiations, took center-stage. At year-end, a truce seemed to have been achieved between the two superpowers, which agreed to speed up negotiations during the first quarter of 2019.

Moreover, several geopolitical risks made headlines throughout 2018, with North Korea, Iran, Brexit and Italian politics topping the list.

Brexit was the centre of attention in the fourth quarter. The U.K. House of Commons vote on the deal reached between Theresa May and the European Union was postponed to January 2019 due to a lack of support in December. We are now navigating in complete uncertainty about what is to come.

In Canada, a factor that probably contributed to the slowdown was weakness in Canadian oil prices. In fact, not only have oil prices been under severe pressure across the world in the fourth quarter (the price per barrel for American crude fell from $75 to $45 at the beginning of October), but the price per barrel of Western Canadian Select slid to around $13 in mid-November. The reason for this major price difference was the difficulty in transporting heavy Canadian crude to export destinations (mainly the U.S.) because pipeline capacity and rail transportation were lacking, leading to a stockpile in Alberta.

As for the bond market, yields started the fourth quarter higher after news broke of a new NAFTA deal, the United States-Mexico-Canada Agreement (USMCA). Rapidly, fear of deterioration in U.S.-China trade negotiations, concerns surrounding Brexit and fear of overtightening by the Fed resulted in equity volatility. The Fed continued to maintain a restrictive tone on its monetary policy at the start of October. This triggered the first decline for risk assets. The central bank’s December release, perceived as accommodative, was not accommodative enough considering the market's state of mind at that time. This volatility led to a safe-haven bid in the bond market, mostly in the 10-year sector. Oil prices also started to fall early in the quarter and continued through to quarter-end. Prices dropped significantly on supply concerns. Although the strong decline in oil prices knocked down Canadian yields the most, these lower rates were not specific to Canada, as 10-year yields also closed the quarter lower in the U.S., Europe and Japan.

The equity sell-off in the fourth quarter impacted the fixed-income markets on both sides of the border. Canadian outperformance in yields last quarter was due to the outsized effect of lower global oil prices on the domestic economy. Also, overall financial conditions worsened, reducing the probability of Fed and Bank of Canada (BoC) rate hikes expected by the markets.

During the period, the Canadian bond market, measured by the FTSE Canada Universe Bond Index, posted a gain of 1.7% (1.4% in 2018). The FTSE Canada Short Term Bond Index posted a return of 1.4% (1.9% in 2018). Finally, the FTSE Canada Long Term Bond Index rose to 1.9% (0.3% in 2018).

The Fund underperformed its benchmark during the period. Duration was adjusted at strategic times using the cash market and derivatives. The duration strategy was the main contributor to fourth quarter performance.

Underperformance in October came mainly from short duration as long-term yields decreased. This drop was driven by a safe-haven bid in the market due to fears of deteriorating U.S. and China trade negotiations. In November, lower rates were not specific to Canada, as they closed lower in the U.S., Europe and Japan. The Fund’s slightly long duration was a positive for performance. December was again influenced by lower yields, mainly due to a dovish BoC and Fed. The short duration during this period contributed negatively to the performance of the Fund. Inflation-linked bonds performed particularly badly in October and November, mainly because of the decline in implied inflation and inflation expectations in the U.S. market.

Going forward, the fund manager continues to actively manage the duration of the Fund. As of the end of December, duration was almost equal to the benchmark. The Fund started the year without any nominal bonds. The fund manager remains nimble and opportunistic on duration, credit and currencies, continues to favour liquidity and remains cautious on illiquid products.

As the first quarter start, one of the key risk factors is the possible trade war between the United States and China, the Brexit negotiations, the European elections in May, the Mueller Report on the links between Russia and the Trump 2016 campaign expected in February, the coming negotiations on the debt ceiling in an acrimonious political climate in Washington and the Bank of Japan policy.

Fund and benchmark performance as at December 29, 20171 year3 years 5 years10 years
IA Clarington Real Return Bond Fund – Series A-1.7%-0.3%2.3%3.5%
FTSE TMX Canada Real Return Bond Index0.0%1.2%3.8%5.0%


Learn more about IA Clarington Real Return Bond Fund

The performance data comparison presented is intended to illustrate the Fund’s historical performance as compared with historical performance of widely quoted market indices. There are various important differences that may exist between the Fund and the stated indices that may affect the performance of each. The Fund’s benchmark is the FTSE Canada Real Return Bond Index, which is designed to track the inflation-indexed Real Return Bond segment of the Canadian fixed income market. Returns are calculated daily, and are weighted by market capitalization, so that the return on a bond influences the return on the index in proportion to the bond's market value. The Fund's geographic, sector and credit quality exposure may differ from that of the benchmark. The Fund may hold cash while the benchmark does not. It is not possible to invest directly in market indices. The performance comparison is for illustrative purposes only and does not imply future performance. Effective January 1, 2009, the manager changed from Sarbit Asset Management Inc. to the current fund manager.