Active investor: Fixed-income investment in a holding pattern

Fixed-income investors are finding themselves at a crossroads these days. Unexpected cuts in interest rates, the rapid decline in oil prices and an excessively harsh winter have made it more challenging to predict what will make the most investment sense over the long term.

The Bank of Canada’s announcement to cut the overnight interest rate by 25 basis points was an attempt to mitigate a relatively disastrous first quarter, says Aubrey Basdeo, managing director and head of Canadian fixed income for BlackRock Canada. “The general consensus is they were trying to buy some time in the hopes that the U.S. economy, which also lost momentum in Q1, will reassert itself.”

Now he says, it’s a matter of waiting and seeing how things will evolve from there. “There is now confidence that the U.S. economy is set for a resurgence. All eyes are more focused there because Canada will likely ride on the coattails of any improvement there – albeit more slowly.”

There is no clear picture however of when things will turn. Basdeo points out that there are a number of key indicators that will be watched very closely in the coming weeks and months.

One is manufacturing sales and merchandise trade data. A change in those numbers will provide a sense of how Canada is benefiting as a result of strong U.S. growth and its overall competitiveness.

Another indicator of growth is the willingness for corporations to engage in capital investments, he adds. “If we see investment equipment picking up, it means corporations are more optimistic about future demand and have more certainty. That would be a tell-tale sign.”

An additional key indicator will be the performance of the Canadian dollar, which has rallied recently from a low point of 78 cents. This recent rally is more of a function of a weaker U.S. dollar rather than a response to improving prospects for the Canadian economy. A sustained rally in the currency, however, would reflect a sentiment change about Canada’s economic prospects.

On the U.S. side, a boost in retail and auto sales could also provide some impetus. “Increased consumer spending shows the consumer has greater confidence, particularly if that spending is largely in bigticket items such as autos and homes. One sign that points to a pickup in the pace of consumer spending is the acceleration in wage growth across all income levels, ” Basdeo says.

He cautions however there are two things that could derail Canada’s recovery. One is weak employment, much of which has been the fallout from the energy sector in Alberta. In addition, manufacturing activity in Ontario and Quebec has not shown any resurgence, despite the weaker Canadian dollar.

Basdeo says attention also needs to be paid to how the consumer debt burden – which currently stand at an all-time high – is evolving. “It is still increasing, however the pace of that increase has been slowing. Nevertheless, the actual level of debt burden suggest the consumer has very little ammunition to spur growth.”

So where does that leave investors? “We simply don’t know which way this will all play out, which puts fixedincome investors at a crossroads,” he says. “If interest rates increase, they could possibly suffer a capital loss on their current fixed-income assets. If they don’t because the economy weakens, interest rates may not decline as much, given the current historically low levels leaving investors with the prospect of a modest capital appreciation. Additionally, given the evolving divergence in monetary policies around the world, there is a lot of volatility and uncertainty that fixedincome investors will have to factor in beyond domestic considerations.”

As investors wait for more concrete indications of economic recovery, there are ways to mitigate risks over the near term, such as shorter duration exposure for fixedincome securities, or diversifying with corporate bonds, he adds. “Casting a wider net or, in short, diversification makes eminent sense, whether you choose to diversify by sector or geography. Right now, investors need to ask themselves if the fixed-income vehicles they have chosen are appropriate or not. If the cost is too high versus the reward, they need to make adjustments and look beyond traditional exposure.”