For the past few quarters, the themes we focused on were synchronized global growth, stable (albeit strengthening) inflation trends and gradual removal of central bank accommodation. Today, we believe most of these themes are largely intact.
Global economic activity expectations in Q1/18 continue to be strong, although they have trended down from last quarter. Similar to the previous quarter, only one of the major countries we track (South Korea) is in contraction (blue bars). This broad-based synchronized strength continues to support our conviction of robust global growth over the first half of 2018.
Continuing with the theme from our last quarterly review, global economic activity expectations in Q4/17 showed further signs of strengthening to cyclical highs among the major markets. There was evidence of even stronger synchronization across the globe, as only three of the major countries we track is in contraction (light blue bars). This broadbased pick up continues to support our conviction of global recovery over the first half of 2018.
Since the financial crisis, while the global economic activity showed signs of strengthening, the recovery had been highly uneven. However, over the past twelve months, we have seen the global manufacturing index (generally a good indicator of economic activity expectations globally) among the major markets strengthen substantially to cyclical highs. What makes this recovery stronger is its synchronized nature across the major markets. Out of the major countries we track, only three (Hong Kong, Korea and South Africa) are in contraction compared to fourteen just two years back. This broad based pick up gives us more conviction in the strength of the recovery.
While we’re still waiting for the political gridlock in the US to resolve and the Trump administration to deliver on its campaign agenda, the focus has shifted to the Bank of Canada’s (BoC) hawkish turn in June, which led to the Canadian yield curve repricing higher and meaningfully strengthening the Canadian dollar. The BoC focused the change on broadening improvement in growth and the diversity of the Canadian economy to adjust to the oil shock. As such, the BoC believes it has become appropriate to remove some monetary policy accommodation.
In our last quarterly commentary, we talked about the renewed market optimism of growth and inflation as Trump’s proposed fiscal stimulus, deregulation and protectionist policies certainly have pro-growth and inflationary tendencies. In addition, a clean sweep by Republicans to gain control of the House and Senate raised market expectations of a smooth passage for Trump’s reforms. The “Trump trade” continued well into Q1/17 and faced its first real challenge in mid-March following the failure of the very first legislative reform tabled by Trump’s administration. The Republican-controlled House abandoned a healthcare bill to repeal and replace Obamacare – arguably an area where all the Republicans have had a unified front. While we certainly do not want to rule out Trump’s ability to deliver, this event was significant in the sense that it calls into question the prospects of his administration’s other big reform initiatives such as tax reforms, deregulation and infrastructure spending.
As we look ahead to 2017, we face renewed market optimism, of growth and inflation as well as new uncertainties of growing protectionist policies. Trump’s surprise clean sweep win in the US elections (versus what was indicated by polls) caught market participants off guard, as most expected a Clinton victory and status quo. The overnight risk-off tone (Equity Futures down 800 points and treasuries lower by 10-15 bps) was gone by market open and had completely reversed in what many phrased as “Brexit playing out in a few hours”. Trump’s proposed fiscal stimulus, deregulation and protectionist policies are certainly pro-growth and have inflationary tendencies. Markets swiftly repriced their expectations taking the S&P500 to record highs and US 10 year bond yields to above 2.6% for the first time since 2014. However, we remain cautious as Trump’s plan does introduce reasons for optimism but with significant longer term tail risks (lower probability events with high market impact) to growth and inflation to the upside as well as downside. As a result, we could experience increased market volatility.
The third quarter of 2016 gave us further indication of the diverging trends taking hold in the US and Canadian economies leading to a divergence in their respective monetary policy stance.
The US economy continued to grow, albeit at low-to-moderate growth, driven primarily by strong consumer spending. While business investments have been largely non-existent/detractor to growth for the past few quarters, we believe that a stabilization in commodity prices should see this trend reverse in the coming quarters. Various inflation measures still remain below the 2% target level while employment numbers have been strong bringing the US closer to full employment.
For most of the second quarter, fixed income markets were driven by the uncertainty of whether the Federal Reserve would follow through with further policy interest rate increases. The vacillation of opinion was evident in the Fed Funds futures market, where the probabilities ‘for’ and ‘against’ summer rate hikes shifted four times during the quarter.
The Fed’s first increase of the Fed Funds Rate since the 2008 financial crisis occurred in December 2015, a move policy makers justified by stronger US economic growth. However, risks from higher US interest rates and a strong US dollar (USD) reverberated through global financial markets in early 2016, requiring the Fed to soften their stance on the pace of future hikes.
The first quarter of 2016 proved to be another see-saw quarter in fixed income markets. The quarter started with volatility consistent with that experienced in equity markets. Continued concerns over China’s growth rate, a slowdown in the North American manufacturing sector, and fallout from collapsing commodity prices steered the markets to traditional safe-haven sectors such as government bonds through to mid-February. During that time, the word “recession” appeared with greater frequency in the financial media and published investment research reports. As seems to be the case with all “crises” post the 2008 Lehman bank failure, this risk of recession “crisis” came and passed, at least for now. As we worked through the last six weeks of the quarter, the risk of recession pricing in the bond market largely unwound. The Cumberland Income Fund’s diversified positioning and elevated short-term bond holdings dampened much of the volatility. The Fund also opportunistically deployed capital (cash) into the higher yielding environment prevalent during the quarter, consistent with our stated strategy.
Regular readers of Cumberland Income Fund quarterly reviews will recall that “increased volatility” is a theme we have threaded throughout our commentaries in 2015. The fourth quarter of 2015 continued on that theme in earnest. Disappointing economic data, low commodity prices, and the U.S. Federal Reserve’s first rate hike in 9.5 years caused material swings in currency, equity, and bond markets. As we exit 2015 and enter 2016 we expect the heightened levels of volatility to continue not only because of global growth uncertainty, but as a result of markets “recalibrating” to a less accommodating Fed. With the central bank of the world’s largest economy finally achieving the much anticipated “lift off” of the fed funds rate in December and hinting at further rate-hikes in 2016, investors are anticipating a headwind not felt in quite a while. Closer to home, the continuing deterioration in commodity prices is causing the Canadian dollar to depreciate and the Bank of Canada to publically discuss unconventional tools to further ease monetary policy. Managing volatility amongst these cross-currents remains the priority of the Cumberland Income Fund. The Fund continues to focus on holding investments and deploying capital with a longer-term view into securities offering stable and sustainable income generation while preserving capital. In the shorter-term, this philosophy prioritizes dampening “downside” risk over participating in “upside” bond market volatility, a strategy we expect to have greater sustainability over the long-run.