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Amelia Carver joined the PH&N Fixed Income team in July as a credit analyst. Previously, she was an engineer in training at a global engineering, project management, and professional services firm.

Recent developments

During the quarter, we announced two enhancements to the PH&N Balanced Pension Trust, our flagship multi-asset solution. We introduced a target allocation of 2% to a global infrastructure fund, starting with a 1% initial allocation that will be built over time. We also made a strategic allocation of 4.5% to global investment grade corporate bonds, sourced from the current allocation to global sovereign bonds. The PH&N Balanced Pension Trust is actively managed and continuously reviewed to ensure it aligns with our current views and capabilities, and that its composition reflects a combination of complementary underlying strategies. The objective of these changes is to provide greater diversification, improve expected risk-adjusted returns, and leverage our growing investment expertise and capabilities.

Market updates

Indices Performance Comparison as of September 30, 2023 (%)

Source: RBC GAM, FTSE Russell, S&P, MSCI

Markets lag amid sticky interest rate fears, while AI drives mega-cap outperformance

Though markets have witnessed strong performance year to date, they posted negative returns in the past quarter amid indications that rates will remain higher for longer. The “Magnificent 7” (the largest U.S. publicly listed companies), which have benefited tremendously from emerging trends in artificial intelligence (AI) and driven the market rally so far, pulled back against this backdrop. While global equity market valuations are not unreasonable, earnings are vulnerable to a contraction in economic activity, which limits the potential upside in stocks.

Markets down in Q3 but strong year to date

Note: as of August 23, 2023. Magnificent 7 is a cap-weighted index which includes Apple, Microsoft, Alphabet, Amazon, Nvidia, Meta and Tesla. Source: RBC GAM, Bloomberg.

In most regions, economic activity has continued to expand so far this year. Stress in the U.S. regional banking system has eased, risk assets have rallied, and North America’s housing market rebounded in the spring. Offsetting these positives is the fact that critical headwinds have intensified. China’s economic rebound from late last year is fizzling, hiring is beginning to slow, and temporary employment, a classic leading indicator of the labour market, is in persistent decline. Furthermore, interest rates have continued to rise and are now quite high by the standards of the 21st century. This represents a major economic headwind. Mid and long-term bond yields have increased palpably due to a combination of quantitative tightening, persistently large fiscal deficits, especially heavy bond issuance in the U.S. following the debt-ceiling showdown, rising Japanese bond yields (which attract capital from other sovereign debt markets) and even China’s efforts to defend its currency (which involve selling foreign bonds to buy Chinese assets).

Recession signals point mostly to "yes" or "likely": we estinmate 65% chance over the next year

Note: As at 07/24/2023. Analysis for U.S. economy. Source: RBC GAM

After a spring resurgence, U.S. housing – the most interest-rate sensitive sector of an economy – is beginning to cool again. Besides, the credit card delinquency rate is rising significantly and is now at its highest point in over a decade. After a long pause, nearly US$2 trillion of U.S. student loans must start being repaid in October, pinching 44 million Americans. Across the border, the Canadian economy is beginning to slow and remains likely to enter a mild recession. While its housing market revived somewhat in the spring, we expect a return to malaise ahead. Affordability has improved from its worst point, but it is still quite poor relative to pre-pandemic levels. Furthermore, the economy has been challenged by a series of temporary shocks that include a major port strike on the west coast and a summer full of major wildfires. That said, the country is experiencing an enormous population boom on the back of record levels of immigration, which has stoked demand for goods and services, making the economy inclined to grow more quickly.

The recession probability we now assign is somewhat lower than in quarters past, with a 65% likelihood for the bellwether U.S. economy, down from 80% before. However for Canada, it appears that a mild recession remains more difficult to avoid.

Global inflation has declined though remains elevated

Note: As of July 2023. Source: RBC GAM, Haver Analytics, Macrobond.

Inflation continues to fall from the highest levels in decades but remains well above normal. The four main drivers of high inflation have all turned. The commodity-price surge following Russia’s invasion of Ukraine has reversed, supply-chain problems have mostly been resolved, monetary policy has moved from extreme accommodation to a restrictive stance, and fiscal policy has become far less stimulative. While inflation has declined relatively quickly during the past year, further material improvements toward the 2.0% target will prove more difficulty in the near term, as gasoline prices have rebounded in recent months and base effects will be less favourable. Nevertheless, we believe that inflation can fall faster than the consensus expectation, aided in part by weaker economic conditions, to just above 2.0% by next year.

Central banks are now near or already across the finish line in their monetary tightening journeys. Emerging market central banks have been leading the way, raising rates before the developed world during this cycle, and some have now pivoted to delivering rate cuts. It is not unreasonable to think that central banks in the developed world may follow suit within the next year. Our model suggests the neutral U.S. Federal (Fed) funds rate is currently 3.4%, but if inflation continues to decline in line with our forecast, that neutral reading falls to around 2% in 12 months. As a result, and in combination with our forecast of a likely recession, it seems unlikely that the Fed funds rate will remain at an elevated 5.5% for an extended period. This view is in line with pricing in the futures market, which flags the possibility of one more 25-basis-point hike by the end of this year, followed by the start of an interest rate cutting cycle beginning in early 2024.

Emerging Market (EM) equities outperform developed markets, but still finish the quarter down

The Canadian equity market ended the third quarter in negative territory, with the S&P/TSX Composite Index returning -2.20% in Q3, underperforming the U.S. market. Energy was the best performing sector in the quarter. The sector benefitted, as the continued economic resilience has supported demand for oil and natural gas. On the other hand, communications services and utilities were the two worst performers, as higher interest rates reduced the relative attractiveness of these high dividend yielding sectors compared with fixed income securities. Going forward, equity returns will ultimately depend on the path of interest rates, the severity and length of any recession that materializes, and its impact on corporate earnings growth.

Global equity markets took a hit in Q3 but are still strong year to to date. Heading into the last leg of 2023, the bullish sentiment that lifted stocks out of a bear market appears to have faded, primarily owing to rising interest rates. The MSCI World Net Index posted negative returns during the third quarter and ended the period with a return of -1.36%. Some of the optimism that drove the first-half rally seems to be misplaced, particularly expectations that the U.S. Federal Reserve would soon be pivoting to lowering rates. This led to a retreat among the stocks that had provided the market with most of its gains. With the recent pullback, the tailwind that the “Magnificent Seven” provided to the market is over, and for the year-to-date rally to continue, it will need to broaden out into into mid- and small-cap stocks. Looking ahead, we believe key risks to equities include tight monetary policy, pressured earnings growth, further upward pressure on yields, broader military conflict in Europe, and escalation in U.S-China tensions.

EM equities, as represented by the MSCI Emerging Markets Net Index, also posted negative returns during the quarter but outperformed developed markets. Concerns that strength in the U.S. economy will keep global interest rates higher for longer had a negative impact on risk appetite. This was combined with ongoing weakness in the Chinese economy and concerns about the property sector. Going ahead, we believe that EM earnings growth will be driven by countries such as South Korea and Taiwan, where we see strong prospects for a cyclical profit recovery amid production cuts, leaner inventories, and demand for semiconductors linked to the explosion of artificial intelligence. Furthermore, we expect a shift in the West’s global trade away from China to provide long-term opportunities for EM exporters. Separately, the fact that many emerging-market central banks got out in front of inflation with rate hikes suggests that monetary policy could move from a headwind to a tailwind.

Bond yields climb as rate hikes start to bite

Turning to fixed income markets, most major bond markets struggled in the third quarter of 2023 owing to rising interest rates. As the long lags of policy actions start to bite, we already see signs that the economy is softening. Inflation has eased substantially, although there is further to go and the risks of overtightening are much higher now.

In terms of the Canadian fixed income market, yield of the FTSE Canada Universe Bond Index ended the quarter at 5.0%, an increase of 0.6% from where it began the period¹. Yields continued to exhibit heightened volatility over the quarter, delivering approximately 25 days on which yields on the index changed by more than 0.05%. The Bank of Canada (BoC) hiked its policy rate by 0.25% to 5.00% at their July meeting, citing an overall resilient economy and sticky core inflation. Conversely, at their September meeting, the central bank held its policy rate unchanged, on the back of softer economic growth but left the door open for future policy rate hikes as they continue to assess incoming economic data.

Headline inflation rose to 4.0% year over year in August, as surging oil prices pushed energy costs higher. The BoC's preferred CPI-trim and CPI-median measures rose more than expected on a year-over-year basis (to 3.9% and 4.1%, respectively) and the closely watched 3-month run rate accelerated to a 4.5% annualized rate for both measures. The 5-year market-implied inflation expectations reacted to the recent rise in CPI by trending above the upper end of the BoC’s 1% to 3% target range, which could further reflect the market sentiment that the BoC has more work to do to bring inflation down.

We expect that macroeconomic developments will be a central focus for the bond market in the coming quarter. There is greater certainty among market participants about how high policy rates may go than there are about how long these high rates will persist until inflation cools substantially. Along the way, we expect that there will be areas of pain and dislocation as the impact of high interest rates is revealed.

FTSE Canada Bond Index Sector Returns Q3 2023

Source: RBC GAM, FTSE Russell

Asset mix

Within our multi-asset and balanced portfolios, we made no changes to our asset mix positioning, which remains set to our neutral targets. Economic and market indicators continue to send mixed and conflicting signals, which is causing significant volatility in both equity and fixed income markets. Valuations between and within the markets are also mixed. Against this backdrop, we remain cautious at this juncture and believe that better opportunities to add risk will come in the future.

Recent publications

Recently we celebrated the 10th anniversary of the PH&N Core Plus Bond Fund and marked the occasion in September by publishing Ten Years of Core Plus, in which we share observations about investor adoption of Core Plus in Canada and perspectives gained from a decade of managing a Core Plus strategy.

Also in September, PH&N Institutional partnered with the CFA Societies in Vancouver, Calgary, and Ottawa to deliver the webinar Emerging opportunities: The case for emerging markets. The webinar featured portfolio managers Laurence Bensafi (equities) and Polina Kurdyavko (fixed income) discussing their respective outlooks for emerging markets, and key themes in portfolio management.