While there are select opportunities in Canadian equities, the bond market looks the most attractive in years.
December 4, 2023
By Sunny Singh, CFA, and Luis Castillo
The Canadian economy is not yet out of the woods, but we think the Bank
of Canada is near the end of its rate hike cycle and the pressure on
household balance sheets should subside over time. We see opportunities
in Energy, while long-term investors can find value in bank stocks. The
fixed income market is the most attractive in 16 years, in our view, and
this calls for shifting exposure from short-term bonds to those with
Consumer spending shows clear signs of softening.
The Canadian consumer should remain in focus in 2024 as
restrictive monetary policy and its impact on consumer finances continue
to work their way through the Canadian economy. The idiosyncratic risks of
elevated household debt levels, coupled with the housing sector’s outsized
impact on the economy, have translated into a weaker economic environment
in Canada relative to its less-levered neighbor to the south. Household
budgets are beginning to feel the pinch of higher interest rates with
consumer spending showing clear signs of softening. According to RBC
Economics, Canadians are spending nearly 10 percent more on essential items than
they were just one year ago. At the same time, the surge in discretionary
spending has slowed with a downtrend in restaurant and travel spending.
After a strong start to 2023, the Canadian housing market also appears to
be stagnating, with the psychological impact of a lower net worth adding
further pressure on Canadian households.
What is the silver lining? Evidence continues to
build that inflation risks are easing as the economic backdrop softens.
RBC Economics does not expect additional interest rate hikes from the Bank
of Canada if that continues. This would bring a sigh of relief to
Canadians with variable rate mortgages, as each rate hike has resulted in
either higher payments or a lower proportion of principal paid. For those
renewing their mortgages over the next few years, the eventual easing of
monetary policy (i.e., lower interest rates) is of greater importance. RBC
Capital Markets estimates that 20 percent, 26 percent, and 23 percent of
Canadian-bank-originated residential mortgages will be up for renewal in
2025, 2026, and 2027, respectively.
The column chart shows the value (in Canadian dollars) of Canadian
residential mortgages up for renewal, as well as the percentage of all
mortgages up for renewal, each year from 2024 through 2027, and in
2028 and beyond. In 2024, $186 billion, or 12% of the total number of
mortgages; in 2025, $315 billion, or 20% of the total; in 2026, $400
billion, or 26% of the total; in 2027, $360 billion, or 23% of the
total; in 2028 and beyond, $260 billion, or 16% of the total.
Note: Distributions do not total 100 percent as renewals for the remainder of
FY2023 are not shown.
Source – RBC Capital Markets, RBC Wealth Management, company reports;
data as of 10/31/23
The trajectory of interest rates and the ultimate impact on the Canadian
consumer will have clear implications for the Canadian banks, in our
opinion. Several Canadian banks recently cited the risk of “higher for
longer” rates when provisioning for future credit losses. Bank valuations
continue to reflect the uncertain environment with the group trading at a
steep discount relative to its long-term average and close to trough-like
levels previously seen during the Global Financial Crisis and the early
days of the pandemic. While it is hard to identify a catalyst for why
valuations should improve at this stage of the credit cycle, we believe
income-oriented investors with a long-term view can find opportunities in
Canadian bank stocks.
We expect Energy sector performance will be largely influenced by
commodity prices. We would highlight energy investors’ ability to reap meaningful
cash returns via buybacks and dividends in a constructive economic
environment. But, even if the challenging economic backdrop persists,
Canadian energy companies are now better equipped to navigate this due to
their fortified balance sheets and reasonable capex needs. We continue to
suggest owning the best-of-breed Canadian energy producers in 2024,
particularly for those investors with an income focus.
On balance, we believe the Canadian equity market should be supported in
2024 by its discounted valuation relative to history, while its exposure
to the resource complex provides a hedge of sorts if inflation pressures
Interest rate risks are becoming more two-sided.
The sharp increase in bond yields seen throughout most of 2023 is
beginning to abate as the Bank of Canada (BoC) appears more firmly positioned on the
sidelines, opting to put further policy rate increases on hold while it
assesses the cumulative economic impact of the string of rate hikes it has
already delivered. Despite inflation remaining much higher than the BoC
would prefer, economic momentum is softening, as evidenced by decelerating
month-over-month GDP growth numbers; this relieves some of the pressure on
the central bank to continue hiking at the same aggressive pace. That
being said, the BoC remains on guard against upside inflation data
surprises, leaving the door open for additional hikes if necessary. With
the BoC likely approaching the end of its policy-tightening regime, and
monetary policy strongly dependent on month-over-month economic data, we
view the risks of interest rates moving in only the upwards direction as
diminishing. In other words, we see the interest rate outlook as becoming
more two-sided, strengthening the case for extending duration within our
Looking back at the history of recent monetary policy cycles reveals that
adding duration to portfolios following the last BoC rate hike has led to
higher total returns relative to short-duration strategies. For example,
as the chart shows, the Bloomberg Canada Aggregate 5–10 Year Index has
consistently outperformed the shorter-duration 1–5 Year Index following
the final BoC rate hike in a cycle.
The line chart shows how different bond maturities have performed
following the end of previous cycles of interest rate increases by the
Bank of Canada. From April 2003 to August 2004, from August 2007 to
May 2010, from September 2010 to June 2017, from November 2018 to
March 2022, and from August 2023 through October 2023. In most cases,
longer-dated bonds (those with maturities of five to 10 years) have
outperformed short-dated bonds (maturities of one to five years).
Source – RBC Dominion Securities, Bloomberg; data through 10/31/23
After spending three years sheltering in short-duration securities while
the BoC rolled out nearly 500 basis points worth of interest rate
it is now reasonable, in our view, to consider lengthening duration in
portfolios. However, despite the more attractive risk-reward profile of duration at
this time, we think it is prudent for investors to lean in cautiously and
calibrate their exposure to their rate volatility tolerances. This view on
duration can be expressed in portfolios while still maintaining a degree
of duration diversification by extending maturities through laddering,
exposing the portfolio to a higher degree of rate sensitivity while
minimizing return volatility, which should lead to a smoother path of
In today’s rising-rate environment, companies are being forced to pay up
to issue new debt and refinance old debt, in many cases at costs that are
three times higher than 2020 levels. Yet despite tighter conditions for
corporations and a more difficult operating environment, the extra yield
compensation demanded by investors for the risk of default on corporate
bonds remains range-bound, and in our view is far from levels that would
suggest economic trouble ahead.
On the other hand, we continue to expect some level of corporate pain, as
well as some degree of negative credit repricing over the near term.
We have therefore reduced our preference for corporate credit, while
maintaining a bias towards higher quality
(i.e., an investment-grade rating) within our corporate bond allocations.
Nonetheless, we see bond yields as broadly attractive from a historical
perspective, with higher starting yields providing some cushion against
further rate increases and/or credit spread widening.
Regardless of one’s approach to bond investing—buying and holding to
maturity, or trading in and out opportunistically—higher base rates make
bond investing more attractive today than during any other period over the
last sixteen years, in our view. We believe the past three years of
surging yields, though painful for existing bond holdings, have increased
the likelihood of achieving equity-like returns via credit instruments
View the full Global Insight 2024 Outlook here
RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC.
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