Global investment leaders and top PM weigh in on recession signals, and what areas look promising right now
The Bank of Canada has come a long way in taming inflation with its aggressive monetary policy tightening. But that has also created distortions in the fixed income space, where signs of economic slowdown – and potential long-term investing opportunity – are flashing for investors and analysts.
“The main bond market signalling remains the 10s/2s and 30s/2s yield curves, have shown deep inversion throughout 2023 and are now inverted by about 130 to 140 basis points,” says Sandrine Soubeyran, director, Global Investment Research at FTSE Russell. “The Canadian yield curve may be less reliable than in the past, after the QE purchases following Covid, which likely caused 10-year yields to drop relative to ‘equilibrium’ levels.”
Soubeyran noted neither credit spreads nor defaults have spiked in recent months, even as signs of tightening financial conditions in Canada – higher policy rates, 10-year yields, and high debt/income levels among consumers, to name some – pile up.
Canadian government bond yields, she observed, have not backed up far in response to the central bank’s tightening as investors look past the inflation shock to a potential 2023/24 recession and, eventually, BoC easing.
“This also signals investors remain concerned about re-investment risks in longer maturities, should they stay out of the market,” she says.
Canada’s economic slowdown is playing out in slow motion, with continued strength in the labour market helping to drive the BoC’s decisions to hike in June and July. Robin Marshall, director of Global Investment Research at FTSE Russell, said the central bank may also be taking out “inflation insurance” through rate hikes to pre-empt a possible wage/price spiral.
“The obvious risk is that it proves ‘too much, too late’ and the economy contracts sharply in 2023/24,” Marshall said. “But they seem to think this is a risk worth taking to protect against a shift to a higher inflation regime.”
As the possibility of recession continues to swirl, the question remains: are Canadian government bonds a haven or a risk for investors? On that, Marshall notes that longer-term Canadian governments now trade further through US Treasuries; 30-year Treasury yields backed up towards 3.9%, compared to only 3.25% in Canadian governments. Inflation, he added, is falling steadily.
“Although there is some debate about whether Canada’s net debt/GDP ratio is artificially low, because of measurement issues, if one looks at gross debt/GDP ratios, Canada is still well below US or UK levels, at just over 100%, versus 133% in the US,” he says.
For Chad Larson, senior portfolio manager at MLD Wealth Management with CG Wealth Management, the inverted yield curve provides a compelling reason to consider investing long-term capital in Canadian bonds.
“We’re near the top of this rate-hiking cycle, so I’m willing to sacrifice a couple of points of yield,” Larson says. “When we get to the other side of this and yield curves normalize, I think we’ll see equity-like returns in long bonds.”
Larson has concerns about investing in conventional corporate bonds priced as a spread above Canadian government bonds. Higher interest rates, he says, are likely to affect growth at corporations across sectors; as margins get compressed and earnings come down, he anticipates a weakening in credit quality among Canadian corporate debt issuers.
“I'm avoiding conventional corporate bonds and looking more into long-duration governments and the private credit market. We’re very active in private credit and direct loans,” he says.
“As banks have tightened up their lending windows, there’s ample opportunity to achieve above-band rates of return in the private credit market, which is a very tough market for traditional investors and advisors to access … it takes significant scale and prowess.”
