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Because you keep asking

Answering more of your investment questions that niggle

Back by popular demand, the Capital Markets Strategy team led by Philip Petursson, Chief Investment Strategist for Manulife Investment Management, answers more of your pertinent questions about current market conditions. Set against a backdrop of a rapidly reopening global economy, rising interest rates, and inflation trending higher, the team looks at the impact on fixed income, the oil sector, and the Canadian dollar. Is it time to take money off the table, and what are the biggest risks for the next 18‒24 months? Read on …


With interest rates increasing, resulting in significant losses for long-term bonds, is it time to cut and run or play the waiting game in hopes of recouping investment losses?


This is a different interest rate environment, heading to the mid-way point of 2021, compared to the start of the year. The feeling is slowly shifting from a theory of transitory inflation to more of a long-term trend of around 2 per cent. The U.S. 10-year yield is now approximately 1.56 per cent, up from about 0.93 per cent in January, and this puts pressure on long-term bonds as there may now be more attractive short-term bonds and credit instruments available.

 Along with inflation trending higher, we may see the U.S. Federal Reserve and the Bank of Canada step in and raise the overnight interest rate towards the back half of 2022. In theory, there may be an opportunity to hold investments for the long term and eventually recover losses; however, that might result in lost opportunity as other areas in fixed income have less loss potential. Alternatively, investors could see yields fall if there was some sort of economic shock — but this is less likely than probable.


"Hope and prayer are not Investment strategies — sometimes it's better to move on."

– Kevin Headland, Senior Investment Strategist, Manulife Investment Management


In a recent survey of small businesses, a large number indicated they would be raising prices based on their higher costs of doing business. Given the environment of rising inflation, it's expected that lower-yielding long-term debt will struggle. Looking at the environment of rising yields and increasing inflation over the next few years, it may be prudent to cut losses on some of the longer-dated lower-yielding debt.


With the material rise in yields, what does this mean for more conservative clients?


"The most likely scenario is that Inflation is moving higher, yields will follow, and the U.S. Federal Reserve will be forced to raise rates."

 – Philip Petursson, Chief Investment Strategist, Manulife Investment Management


The Capital Markets Strategy team feels that the U.S. Federal Reserve is backed into a corner with inflation. It may see that inflation isn’t transitory, but if that’s declared, it could spook the fixed-income markets and yields will go much higher than they are today. As far as inflation expectations go, the 10-year average is 1.7 per cent, but inflation of 2.5 per cent to 3 per cent is reflective of the economic environment that we’re in right now.

 The quest for yield will be tough for more conservative income-seeking clients. The playbook for fixed income is pretty straightforward when it comes to an environment of rising rates with a steepening yield curve. The focus will need to be on reducing duration, with less than a five-year duration being a good benchmark, depending on where the yield curve is steepening. After that, looking lower on the credit spectrum may be in order. Corporate credit and high yield may outperform longer-dated government debt in this environment. High yield tends to do well in a steepening yield curve environment because the economic outlook is improving, reducing the risk of default in higher-yielding fixed income. Remember though that this is issuer sensitive, and picking the right issuers and companies to invest in is important.


There has been a large run up in the Canadian energy sector. Has the sector realised all of the gains for the year, and what can we expect for the rest of the year?


This really comes down to two questions:

  • Should I buy into the energy sector if I don’t own it?
  • What do I do with my energy sector holdings this year?


The oil and gas sector has had a big run up on the back of the rapid reopen, with some companies reaching their pre-pandemic levels. However, caution is advised. The Capital Markets Strategy team thinks it may be good to avoid commitments of new capital at these levels, even though they see risk to the upside, but continue holding positions that are already in place.


What does the current economic environment mean for the Canadian dollar?


At the start of 2021, we predicted 0.79–0.81 cents for the Canadian dollar, and we’re already higher than that now. The Canadian dollar, absent of any policy changes from the Federal Reserve or the Bank of Canada, has become a petrocurrency again. Fair value for the Canadian dollar with today’s oil price is around U.S. 0.84, so we think that’s where we’re headed. If the price of oil changes, then that will affect the dollar.


Where could we be wrong? While we think that OPEC, as a group, would act in their best interest and keep the price of oil stable, there’s always a risk that a single country with low production costs could open the valves and start pumping oil at a price that’s profitable for them and flood the market with product. This would bring down the cost of oil and the value of the Canadian dollar. However, that’s not really a situation that the Capital Markets Strategy team expects to see, as we believe the risk is to the upside for oil and the Canadian dollar through 2022.


Are emerging markets still attractive given their relative underperformance compared with developed markets year to date?


"We’ve dedicated a sleeve of the model portfolio to the emerging markets because over the long term, we like the fundamentals and see the key drivers for growth."

– Macan Nia, Senior Investment Strategist, Manulife Investment Management


We‘ve decided to add a dedicated sleeve to the model portfolio for emerging markets because we believe in the story. These markets are evolving — they used to be focused very heavily in materials and energy, but now we're seeing them increasingly made up of technology and service sector companies. Likewise, with the geographical allocations, emerging markets used to be made up of countries like Brazil, Mexico, and South Africa. Today 80 per cent is exposed to emerging market Asia. For more Information, refer to our recent Investment notes here and here.


The most important thing to remember about emerging markets is that it’s not a tactical trade, it’s a strategic investment. Any weakness or underperformance in this sector right now would represent an opportunity for investors.


Our research also shows that when you get a correction outside of a recession, the one-year forward return is positive 90 per cent of the time. We argue that the emerging markets got the correction that the U.S. markets should’ve received. The U.S. markets barely lost 5 per cent when the buyers came out in droves. So, when we see that emerging markets are 10 per cent off the top, this allows investors that were hesitant a good opportunity to get in.


And when inflation is trending higher, emerging markets tend to do very well. When we look at the growth and inflation momentum matrix, we can see that those are ideal conditions for emerging markets. We also believe in the long-term structural changes in Asia, which supports our decision to hold a 10 per cent allocation in the model portfolio.


The S&P 500 is up 11.5 per cent — is it time to take money off the table?


In just the first quarter of 2021, we've realized the average annual long-term return for the S&P 500 for the year, but we feel there’s more room for this market to grow. Looking back all the way to 1929, our research shows that momentum begets momentum. When the markets are up 20 per cent in a one-year period, the most likely scenario is that they will be up another 10 per cent in the following 12-month period. Absent a recession, 60 per cent of the time, market returns are greater than 10 per cent, and 35 per cent of the time, they’re greater than 20 per cent. We do expect that the pace of the market growth will smooth out with some corrections along the way, but the Capital Markets Strategy team feels that markets still have room to grow and will end the year higher from here.


What’s the major risk for the markets in the next 18‒24 months?


"I rate this as a low probability, but a central bank policy misstep could spook the bond market, which in turn would spook the equity market. A policy misstep could see the unwinding of liquidity too soon or the raising of interest rates too quickly. The 2009‒2013 taper tantrum offered key learnings for central banks, which should help guide future decision making."

– Kevin Headland, Senior Investment Strategist, Manulife Investment Management


"A black swan event that nobody sees coming. I know that it won’t be raising the capital gains tax in the U.S. The U.S. has raised the capital gains tax four times, and each time, the markets bounced back. It’s like a market shock from geopolitical risk."

– Macan Nia, Senior Investment Strategist, Manulife Investment Management


 "I think the biggest risk this year is a good news story for some — that this becomes one of those bull markets that just won’t let you in. Momentum begets momentum, economic indicators are picking up steam, countries are reopening. There are a lot of investors sitting on the sidelines in cash just waiting for a pullback or a correction to get back into this market that they sold out of last year for geopolitical risks, etc. As a good friend once said, ‘Sometimes the cruelest thing about a bull market is that it just won’t let you in.’"

– Philip Petursson, Chief Investment Strategist, Manulife Investment Management

A rise in interest rates typically causes bond prices to fall. The longer the average maturity of the bonds held by a fund, the more sensitive a fund is likely to be to interest-rate changes. The yield earned by a fund will vary with changes in interest rates.

Currency risk is the risk that fluctuations in exchange rates may adversely affect the value of a fund’s investments.

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