Market Commentary
The prolonged conflict in the Middle East continues to keep energy prices elevated. More importantly, ongoing drawdowns in inventories and strategic reserves are approaching operational minimums. According to commentary from the CEOs of Exxon and Chevron, shortages could begin to emerge by the end of June, subject to regional conditions and individual supply patterns. As shortages develop, demand destruction is likely to follow, weighing on economic activity and eventually overtaking near-term inflation concerns associated with the supply shock. Against this backdrop, the European Central Bank’s quarter-point rate increase appears to add further headwinds to an economy that requires support.
The Canadian bond market has begun to reflect this weaker growth backdrop. In May, the yield on the long Government of Canada bond declined 13 basis points to 3.79%, while the two-year yield declined 17 basis points to 2.78%.
Consumers in both the U.S. and Canada remain under pressure from higher energy and food prices. This burden is likely to intensify as inventories and reserves are depleted. In the U.S., wage growth has fallen below inflation, leaving real wages negative, while the savings rate has declined to recent lows as consumers draw on savings to maintain consumption.
While headline U.S. economic data remain resilient, the underlying picture is increasingly bifurcated. AI-related infrastructure spending remains robust, while broader economic activity appears flat. Labour markets also remain in a “no hire, no fire” environment, reflecting limited momentum beneath the surface.
Canada has entered a technical recession, with two consecutive quarters of negative GDP growth. The surge in gold imports was a significant contributor to the negative first-quarter print; however, the broader details were also weak. Business investment declined for a fifth consecutive quarter, while consumer and government spending were soft. This combination increases the risk that the technical recession evolves into a more pronounced economic downturn.
Fund Performance and Positioning
The Tactical Sovereign Bond Fund remains positioned for a weaker Canadian economic backdrop. Exposure to 30-year Government of Canada bonds continues to be a key component of the strategy. These positions have been actively traded to improve the Fund’s average cost, while overall duration has been modestly reduced through a smaller allocation to long bonds.
Weaker Canadian economic data should also place downward pressure on the Canadian dollar relative to the U.S. dollar. The Fund has been positioned to benefit from this environment through a long U.S. dollar exposure. Following profit-taking during the month, the Fund currently holds no long U.S. dollar position; however, the team is seeking opportunities to re-establish the exposure at attractive levels.
For May, foreign exchange trading contributed and approximate 0.18% to Fund performance. Active trading in long bonds added 0.30%, while higher prices on the Fund’s long bond position contributed 1.01%. Series F returned 1.5% for the month, outperforming the benchmark, the S&P Canadian Sovereign Bond Total Return Index, which returned 1.1% over May.
Outlook
As global markets prepare for potential shortages in energy, fertilizers, aluminum, and other commodities affected by the conflict in the Middle East, Canada faces the additional challenge of declining investment spending on a per-capita basis, as highlighted in the Chart of the Month below.
Slower growth, and recessionary conditions in Canada, should place further downward pressure on long-term bond yields and eventually force central banks to reduce short-term interest rates. As the yield curve flattens, consistent with prior recessionary periods, Canadian long bond yields should decline, supporting long-duration bond prices and Fund performance.
Chart of the Month
Non-residential Capital Stock per Available Worker by Type
Source: Source: C.D. Howe Institute, Statistics Canada