Portfolio Update

Despite a slight pullback in the month of April, equities generated strong positive returns year-to-date as market consensus converged on an economic soft-landing scenario and companies reported solid earnings. The total return for the S&P/TSX was 6.1% since the beginning of the year, while the S&P 500 returned 10.5% (in Canadian dollars), the MSCI ACWI 9.0% and the MSCI emerging markets 7.1%. Fixed income investors have been laser focused on the likelihood and timing of rate cuts, and hints that central banks may delay the shift to a more accommodative monetary policy sparked volatility in bond markets. The FTSE Canada Universe Bond Index was down 3.2% year-to-date.

Unlike equity investors, bond investors have not been well rewarded over medium and long-term time frames (Chart 1). We are unsurprised by this outcome. Indeed, we have managed to successfully navigate a tumultuous post-pandemic period in bond markets by ignoring short-term market noise and focusing on the longer horizon, and by making strategic decisions using a risk/reward framework while evaluating the merits of each bond along the yield curve. The result has been an outperformance of our bond portfolios over both short and longer periods.

A Strategy to Preserve Capital

We had warned both before and after the pandemic that longer-term bond yields appeared disconnected from economic fundamentals. By steering clear of the excessively valued long-term end of the yield curve, we were well positioned to avoid the majority of the bond market’s sell-off as inflation began to rise and central banks tightened rates. In addition, our strategic asset allocation decision to maintain a very short duration in bonds while favouring attractively valued equity investments benefited the performance of our balanced portfolios.

Over the last two years, we have made tactical adjustments to our fixed income portfolios to capitalize on the opportunities that emerged in the face of changing market fundamentals. First, we increased our exposure to high quality corporate bonds when spreads widened to enticing levels due to speculation the global economy would fall into recession. At the height of concern over global growth, a BAA-rated 5-year corporate bond yielded nearly 5.75%, a 190-basis point spread to a same maturity Canadian government bond. Second, we progressively lengthened the duration of our bond portfolios by adding seven to ten-year government bonds, an area of the yield curve that we had previously shunned, when the 10-year yield spiked to 4% on inflation fears, a level that had not been reached since 2007. We judged this to be an attractive entry point given our estimate of fair value was around 4%-4.5%, based on a view of the economy’s potential real growth rate (around 2%-2.25%) and inflation expectations over the next decade (2%-2.25%). Both decisions – adding corporate bonds and increasing duration – were based on our analysis that investors were mispricing securities due short-term pessimistic views that we did not share.

Our price discipline has remained steadfast amidst the shifting tides of market speculation. This has helped us rank within the first quartile on eVestment among Canadian fixed income (core) strategies, a competitive landscape of 60 firms and 203 strategies, over one, three, and five-year periods¹.

Concluding Thoughts

By strategically positioning our fixed income portfolio and capitalizing on opportunities, we have been able to outperform our bond benchmark all the while mitigating undue risk. Since April 2020, the early stages of the pandemic, our bond strategy has generated a modest positive annualized return of 0.7% while the FTSE Canada Universe Bond Index recorded a -2.2% return². Pension investors and their beneficiaries who sought to immunize their liabilities by investing in long-term bonds have suffered substantial losses over the last four years as the 30-year Canada government bond experienced a 42.5% decline in price over the period.

Within the context of balanced mandates, we remain overweight in equities where the risk to reward relationship has been the greatest. Given our base case forecast for slower yet still positive global growth in 2024 and for improved prospects thereafter, we expect our equity holdings to provide meaningful returns over the next 3-5-year horizon. With a continued emphasis on long-term vision and sustainable growth, we remain confident in our strategy to favour companies with strong fundamentals and attractive valuation.