After a brief reprieve in July, August saw the return of economic and geopolitical tension. Tariffs, a stronger US dollar and higher US interest rates have battered Emerging Market (EM) economies and their currencies (see the Table below). The MSCI Emerging Markets Index, a measure of emerging market stocks, is down 20% from its peak. The stronger US dollar, rising US interest rates and their huge stock of USD denominated debt is starting to impact the growth of these EM countries, as they depend on foreign investors to fuel their economic expansion. Some have reacted by boosting domestic interest rates, cutting government spending and even asking the IMF for assistance.
Additionally, China, who is a major trading partner for many EMs, is hitting a soft patch and has had to deploy fiscal and monetary stimulus to prop up its economy. The prospect of US tariffs on $200bn of Chinese imported goods in September is of course an additional headwind.
Source: Bloomberg, IMF World Economic Report - April 2018 and Ninepoint Calculations.
For now, Central Bank officials and market participants in developed economies do not seem too worried about contagion stemming from EM stress, but if things don’t start getting better soon, it will surely put a dent in the global growth narrative (the countries listed above make up ~40% of world GDP).
Closer to home, Trump is trying to force Canada’s hand by imposing a last-minute deadline on NAFTA negotiations. They now have until September 30th to come up with a deal (after the failed deadline of August 31st). Our hunch (and that’s really all anyone can claim to have regarding this topic) is that this comes down to the wire as both Trump and Trudeau play a game of chicken, both trying to save face ahead of their respective electoral contests (US mid-terms in November and Canadian General Election in 2019).
Given all these headwinds, we closed our Government of Canada 30-year bond short position for a small profit. We view the short-term risk on interest rates as skewed to the downside if NAFTA negotiations remain as tense as they have been in recent weeks. Additionally, global macro headwinds (EM stress) have intensified and as such, we would rather not be short a safe heaven asset.
In terms of positioning, we continue to high grade the portfolio by keeping High Yield and Preferred Shares low, deploying cash and maturing bonds into short dated investment grade securities. We expect corporate issuance to pick up in the fall, as is usually the case after the summer break. This should allow us to deploy upcoming bond maturities into higher yielding assets. As shown in the table below, almost 60% of the fund is now invested in short (<3 years) duration securities, a very defensive posture.
With 2.1 years of duration and a 3.5% yield to maturity, we are comfortable with the portfolio and are well positioned to take a wait and see approach.
Until next month,
The Bond Team: Mark, Etienne and Chris
Diversified Bond Fund Portfolio Characteristics: