Investor worries over when the U.S. Federal Reserve would begin tapering its massive bond buying program re-emerged in August, pushing bond yields higher. In the U.S., the yield on the benchmark ten year U.S. Treasury Bond rose from 2.60% to 2.78%. It was the same situation in Canada, where the yield jumped from 2.45% to 2.61% on the Government of Canada ten year bond.
This continued rise in yields caused losses in the bond market, with the DEX Universe Bond losing 0.60%. Not surprisingly, with their higher yields, corporate bonds outperformed government bonds, and short term bonds fared better than longer dated bonds. The DEX Short Term Bond Index was off by 0.07% and the DEX Long Term Bond Index fell by nearly 1.4%.
Political tensions rose as the global community discussed how to best punish Syria for the August 21 chemical weapon attack on its own citizens. Commodities, particularly oil and gold were higher. Oil gained more than 4% as worries over a new conflict in the Mid-East worried investors. This also sparked a rally in gold, which gained more than 6% on safe haven buying.
With commodities on the rise, the S&P/TSX Composite Index gained 1.55% while global equities were mostly lower. The S&P 500 lost 2.9% in U.S. dollar terms and the MSCI EAFE Index was down by 1.3%. For Canadian investors, the returns were better, thanks largely to a drop in the value of Canadian dollars. When we factor in the weakening currency, the S&P was only down 0.4% and the MSCI EAFE was actually higher by 1.2%.
As we enter into October, there are many reasons to be cautious. While the situation in Syria appears to be under control at the moment, it could fall off the rails at any time, creating even more uncertainty in the Mid-East. Investors remain worried about the Fed tapering and its impact on yields. Expectations are that an announcement will be made at the Fed’s September policy meeting.
Other sources of uncertainty include the upcoming debt ceiling negotiations, and the announcement of a new Fed Chairman. Recent reports say that President Obama is in the final stages and is set to announce former Treasury Secretary Lawrence Summers as early as next week. This will concern traders given Mr. Summers’ negative views on quantitative easing.
Despite the potential for high volatility this autumn, I am keeping my investment outlook largely unchanged. Mid to long term, I favour equities over bonds because with a longer term bias towards higher interest rates, the return expectations for fixed income remain under pressure. Still, there is the potential for a short term rally in bonds, as some believe that yields may have jumped ahead of the fundamentals, and some level of pullback may be necessary, given the economic growth environment. Within fixed income, I continue to favour shorter durations over long, corporate bonds over governments, and where possible, high quality global bond exposure. These strategies should help to minimize the impact of rising rates.
Within equities, I continue to favour the U.S., but am starting to warm up to global, large cap names in Europe. Canadian equities should remain volatile, and may be prone to a drop if we see a sustained pullback in gold or oil. There are also some concerns about the earnings outlook for banks, particularly if we see any sort of pullback in the Canadian housing market.
In this environment, I favour actively managed funds over those that look like the index. This is true of both equity and fixed income funds. I firmly believe that if you stick with high quality funds, managed by strong managers with disciplined processes in place, you should be able to withstand the volatility better than with a more passive strategy.