Manager commentary - Q4 2019

The quarter was marked by a significant easing in global trade tensions, and a slight shift in global monetary policies from easing to pause. Volatility in interest rates was relatively subdued, with U.S. 10-year Treasury yield trading in a 25 basis point range.

October started with some optimism about a possible U.S.-China trade deal, after talks resumed on October 10. Markets focused on a possible mini-deal that would leave the difficult negotiations for later, and rates sold-off moderately. The positive tone was also reinforced by the October 25 news that the U.K. was seeking an extension for Brexit until the end of January, diminishing the probability of a hard Brexit on October 31.

Despite those signs of decreased uncertainties, The Bank of Canada (BoC) surprised markets on October 30 by adopting a more dovish tone, leading to a rally in interest rates. The BoC noted that the resilience of the Canadian economy would be tested by slower global growth and the trade conflict. The BoC opened the door to interest rates cuts in 2020 if needed. The jury is still out on whether rate cuts will be needed as a more accommodative fiscal policy was announced following the federal elections, which were won by Trudeau’s Liberals, although only with a minority government.

The U.S. Federal Reserve (Fed) had its monetary policy meeting on the same day as the BoC in October. It cut rates by 25 basis points and signaled a likely pause. The pattern of 75 basis points of cumulative rate cuts and then a pause is consistent with the two previous episodes of “mid-cycle” adjustments of the 1990s.

November was slightly more volatile for markets, with sentiment alternating between risk-on and risk-off on headlines regarding the potential U.S.-China trade agreement. President Trump’s statements contributed to the volatility as he sounded positive on negotiations but also threatened to impose additional tariffs on China. Speakers from the BoC also gave speeches three days apart that seemed to reflect conflicting views, with Senior Deputy Governor Wilkins sounding more dovish than Governor Poloz. Economic data was mixed, with strong retail sales, but weaker employment, export and housing numbers.

Optimism on U.S.-China trade tensions returned in December as it seemed more and more likely that the two countries would agree on a phase one deal. The oral agreement was finally announced on December 13 but lacked some important details, such as China’s commitment on agricultural purchases. Moreover, the U.S. only removed part of the tariffs that had been imposed on China and delayed additional ones planned for December 15. The initial market reaction was negative, but interest rates still drifted higher toward month-end. Economic data in the U.S. was relatively strong except for the manufacturing ISM, which stayed around 48 during the quarter. Consumer-related data and job creation were the bright spot. In terms of economic surprises, the U.S. fared much better than Canada, which showed some signs of weakening growth. Job creation was negative in both October and November, and housing data were also relatively soft.

Globally, the last quarter of 2019 was marked by continuing signs of stabilization in growth, but no signs of a strong rebound. The European Central Bank (ECB) did not change its monetary policy stance at its October and December meetings, which was expected after the announcement of a strong easing package in September. Christine Lagarde replaced Mario Draghi as the central bank governor and the transition went smoothly.

General elections were held in the U.K. on December 12, and Prime Minister Boris Johnson obtained a clear mandate to deliver Brexit, which will probably happen at the end of January. However, uncertainty on the future trading relationship with the EU remains and the timeline to agree on a deal before the end of 2020 seems ambitious.

China kept delivering tidbits of monetary stimulus (5 basis point decrease in the 1-year medium-term lending facility and 1-year loan prime rate) to try to cushion the blow from the trade war and prevent GDP growth from slowing below 6%. The People’s Bank of China’s actions are limited by a relatively high inflation rate of 4.5%, mostly explained by food prices. Protests in Hong Kong continued during the quarter, and the pro-democracy movement was encouraged by good results at local elections. There were some concerns that the U.S. would try to link an outcome on the trade deal with the situation in Hong Kong but those worries mostly dissipated toward the end of the quarter.

Going forward, it is likely that central banks will keep assessing the impact of easing measures delivered during 2019. Unless global economic growth resumes its downtrend, central bankers will happily stay on the sidelines in the first part of 2020.

One of the main contributors to the Fund’s performance during the quarter was our duration management, specifically the use of U.S. Treasury futures. Since we are always nimble on our duration management, we can take advantage of the volatility in interest rates. Another contributor was our overweight to corporate bonds, as this segment of the market clearly outperformed the benchmark in the fourth quarter. The last positive contributor was our overweight to municipal bonds. We favour non-rated Quebec municipal issues for the good carry they provide while bearing a low interest rate risk since their duration is low.

Despite the Fund’s underweight to Federal bonds, a segment that underperformed the benchmark, it was still a detractor from performance as the bonds owned are long duration and did not perform well the previous quarter. Finally, we were underweight the Provincial segment, which detracted form Fund performance as the segment outperformed the benchmark during the period.

For the coming months, we are more optimistic about credits in general. We believe that demand for this type of product in North America will not fade with the expected recovery of economic data in developed markets and the thirst for carry caused by negative interest rates in Europe and Japan. According to external research, there is a high probability that the recovery in U.S., Europe and China will be stronger than what the market expects, which should push rates higher. In addition, the possibility of fiscal stimulus from the German government could add pressure to rates. This provides a good environment for credits in general. We plan to increase our exposure to this sector in the next quarter as we think carry will be important for total return in 2020.

We will monitor both North American central banks (the Fed and BoC) to understand where monetary policies are going, which will guide us on how to allocate our duration exposure between the U.S. and Canada. Canadian economic data has shown signs of weakness lately and if this were to continue in Q1 2020, the BoC may turn a little more dovish when the Fed is expected to be firmly on hold. The Canadian dollar could suffer as rates would reprice the possibility of rate cuts from this change in tone and opportunities could arise to gain from this divergence between the two central banks.

It is also noteworthy that the ECB will conduct a strategic review that could bring some volatility if negative interest rates are perceived to be more detrimental than effective in the conduct of monetary policy going forward.

Finally, inflation data in the U.S. and Canada are starting to show some signs of strengthening. Combined with the fact that the Fed wants to let inflation go up in the U.S., we think that Canadian real return bonds and U.S. Treasury Inflation Protected Securities are good investments for the portfolios should inflation really start to increase. As always, we stay nimble and opportunistic on duration and currencies while favoring liquidity.

It is a presidential election year in the U.S., which may bring a lot of noise and volatility. The possibility, albeit small, that a far-left Democrat candidate wins the primaries worries equity markets. Also, the Trump impeachment process, while not a game changer, is another event that may disturb the markets in the coming weeks.

Regarding the U.S.-China trade war, a phase one deal seems to have been reached. Although there is less uncertainty about this conflict, volatility can persist as tariffs will only be removed by phases and problems can easily arise in the future, especially when both parties will be negotiating a phase two deal.

Finally, the Middle East, Hong Kong, Taiwan, Brexit and North Korea are all areas of possible or ongoing tensions that must be monitored closely.

Fund and benchmark performance as at December 31, 20191 year3 year 5 year10 year
IA Clarington Bond Fund – Series A5.9%2.2%1.8%2.7%
FTSE Canada Universe Bond Index6.9%3.6%3.2%4.3%

 

Learn more about IA Clarington 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 Universe Bond Index, which is comprised of Canadian investment grade bonds and has significantly different portfolio duration characteristics. The FTSE Canada Universe Bond Index consists of a broadly diversified selection of investment-grade Government of Canada, provincial, corporate and municipal bonds issued domestically in Canada. 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.