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Peering out of the foxhole

BlackRock shares this month's Canadian Fixed Income outlook.

No one could blame investors for wanting to hunker down and dig in amid the volatility that wracked markets in December. As bad news bombarded equities and flattened the yield curve even further, a year defined by uncertainty descended into fear, and then came to a somewhat ignominious end: the worst in a decade for stocks, and a rocky one for fixed income, too.

Shell-shocked as 2018 left markets, this is, after all, a new year, so let’s peep our heads out of the trenches and take a look around. When we do, our (careful) view for 2019 is of a defining battle of perception – between the markets’ fearful forward reconnaissance and the much more sanguine view held by monetary policymakers.

The fact is, as much as investors have been running for cover, central banks don’t see the same gathering storm. When they look at fundamentals, such as unemployment at historic lows, they see an economy operating at or above capacity. Policymakers see the data and the data are saying they need to remove accommodation.

Meanwhile, markets are stressing about two things. One is what’s going on beyond the borders of the United States. The U.S. Federal Reserve has a model for domestic growth that supports further rate increases, but markets are paying attention to the less rosy global growth picture: weakness in China, the related and metastasizing effects of the Sino-U.S. trade war, Brexit chaos, currency and fiscal crises in emerging markets, and so on. They are waiting for the next shoe to drop – namely, evidence of the global slowdown hitting America’s shores. Some of the higher-frequency data (as opposed to lagging indicators like GDP and employment) have indeed been flashing weakness. In December, the U.S. purchasing managers’ index came in at a 15-month low, and the ISM* manufacturing index fell to its lowest level in more than two years. Meanwhile, commodity prices fell off the deep end.

Markets are also factoring in something else: there is less liquidity in the system, owing to tighter financial conditions as the U.S. Federal Reserve removes accommodation. Reduced liquidity is a headwind to risk asset prices, particularly when coupled with concerns about earnings and growth. And we have seen those concerns materialize already, in the form of earnings estimate revisions from Apple and Delta Airlines, for example. Clearly, trade issues are bubbling up for at least some U.S. companies, and even the White House is saying we should expect more of the same.

So, between negative investor sentiment and monetary hawkishness, which view is correct? To our mind, that question is less salient in the near-term than is the simple observation that the two views are colliding. The conflict might not yield a victor for quite some time, but in the meantime the push-and-pull is likely to introduce more volatility than market participants would like.

From a Canadian economic perspective, we expect growth will slow, for a few endemic reasons. The oil patch has been getting clobbered. While employment is high, the December data show that Canada is gaining part-time jobs and losing full-time jobs. There is no sign of wage pressure building: December wage gains came in at 1.5% against an expected 1.6%. With a slowdown in the offing, we are fairly confident that any Bank of Canada rate hikes will be off the table for the first half of the year.

That is not much of a change from our December outlook, when we forecast slowing growth but saw no signs of a recession. We are still not forecasting a recession for 2019, although we do think the risk has increased, depending on how dire the situation becomes in the oil patch, or how damaging the negative feedback loop of higher rates and lower consumer spending proves to be.

For now, the question for fixed income investors is whether interest rates are sustainable in the current environment. Unlike just a few months ago, it is no longer a certainty that rates will take off. With the yield curve as flat as it is, there could be opportunity on the short end – at least for investors who are not in the recession-is-around-the-corner camp. In that case, reducing duration and taking on more spread risk might be a tactic to consider. Earnings season presents a downside risk to this approach; the question is how much of that downside is already factored into asset prices.

In short, investors might not want to charge from their bunkers just yet, but they can still peer toward the horizon for signs of hope.

Discipline is what it takes to block out the noise, commitment is what it takes to walk the path to financial success and patience is what it takes to reach the goal.

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