Watching CNBC and BNN, you would think that the end of days was upon us. Stock, bond and gold markets have tumbled in unison and many investors are running for the hills. One word – relax. It’s summer. Let’s take some time to look at this all rationally.
I think a lot of the last few weeks have been an overreaction to the true situation. U.S, Fed Chairman Ben Bernanke only said that he will be slowing down bond purchases (which we already knew) and would base that slowdown on economic statistics (which we already knew). The only thing that sort of came as a surprise is that he expects to meet the thresholds sooner than he had originally expected – later this year or early next year instead of next year or later. He also reiterated that even once they stop buying bonds, rates will still remain on hold for a while. So really, I don’t get the panic.
Looking at the bigger picture, economic fundamentals in the U.S. are on the rebound. Housing is doing well, and consumer confidence is strong and gaining strength. Granted, it’s a long way from generating big job numbers or anything close to having the economy running at full capacity, but it continues to move in the right direction. In Canada, it’s less of a rosy picture, so rates here are more than likely on hold for even longer.
Another thing that has been pointed out is that it’s an odd time in that equities, fixed income, and gold have all dropped at the same time. Some have even suggested this is a new normal. I don’t think so. I see it as more of a short term reaction to all the liquidity in the system. For the past few years, many equities have traded more on overall market liquidity than company specific fundamentals. With traders being told the tap was being turned off sooner than they thought, many panicked and sold out their positions.
Bonds were hit because many feared that short term interest rates would rise, pushing up the yield curve. This caused some traders to sell, which encouraged others to sell and so on. Gold was sold down because with the prospect of less liquidity in the system, the outlook for inflation has been further reduced. Looking ahead, I fully expect that equities will return to trading on fundamentals again, and honestly, those fundamentals aren’t too bad. Bonds and gold will return to doing what they do, so that historic negative correlation profile is expected to return to normal soon.
Still, we’ve known that rates were going to move higher for a while. That’s why I’ve been telling anybody who will listen that they need to diversify and reduce the traditional bond exposure in their portfolios. This including my suggestion to move into corporates, shorten duration and go global when you can. In my Recommended List, I pulled Dynamic Canadian Bond Fund and replaced it with Dynamic Advantage Bond. The managers are more active in adjusting its duration, and it has a much broader asset allocation than the Dynamic Canadian Bond Fund.
I’m also considering recommending a shift into PH&N Total Return and TD Canadian Core Plus Bond over the current funds on the Recommended List, again, because they have more flexibility to play defense in a rising rate environment. I also continue to recommend Manulife Strategic Income and recently added RBC Global Corporate Bond. I think these funds will hold up very well, at least on a relative basis going forward. They both have relatively short durations and offer a much higher yield profile than a pure Canadian bond fund. They are also actively managed, and currency exposure is hedged.
I like floating rate funds, but you can only use them for a portion of your fixed income exposure. It’s all pretty much unrated debt (although most is secured), but it’s more risky than it looks on the surface. Take a look at how they got slammed in 2008, dropping as much as many equity funds did. In the floating rate space I like Trimark’s Floating Rate Income Fund. It’s probably the most conservative. I don’t mind the Manulife offering, but have noticed that it is one of the most volatile in the category. You’ll probably get decent returns out of it, but it will likely be a bumpier ride.
I expect that in the near term, real return bonds are going to continue to be sold off. With the threat of inflation largely contained, I reckon they will trade like long-term bonds. With upward pressure on yields, we’ll see continued downward pressure on prices. It’s a pretty tough time to justify having much, if any exposure to these in a portfolio right now.
Regardless, I think the past couple of weeks likely represent a turning point. That doesn’t mean we need to panic. In fact, now it is probably most prudent to not do anything rash, and keep focusing on disciplined portfolio construction. Volatility is likely here to stay in the fixed income space for the near term, and equities will remain volatile. A good asset mix can be a strong defense through this, but unfortunately some losses are going to happen.
We knew this day was coming, and I think this is just a preview. Hopefully the traders will get it out of their system and rationality will soon return to the markets. Until then, enjoy the summer!
If you have any more specific questions, please do not hesitate to contact me.