How does Canada’s economic environment today compare and contrast with the country’s Goldilocks period of a decade ago?
For those too young to remember, from 2004 to 2007, fixed income markets witnessed a period of low volatility, even as central banks were raising rates and the yield curve flattened. GDP growth was steady, yet inflation was low. The period came to be known as the Goldilocks economy – hot enough to grow near potential, but cool enough to avoid creating runaway inflation.
Pivot to today, and it looks like we are in a stage of the cycle that is the same, but different. And we can see just how stark those similarities and differences are from the evolving stance of the Bank of Canada. Remarks from governor Stephen Poloz – for example, during comments at a recent meeting of the International Monetary Fund in Washington and following the October rate announcement, which held the overnight rate steady at one per cent – suggest that the path forward is anything but predetermined.
What does all this mean for fixed income investors? In charting asset allocation decisions, we see the current situation as a replay of the economy of 2004-2007, but with some key differences.
- On the similarity side, we have low volatility and a flattening yield curve; on the other side, we seem headed into an elongated hiking cycle and a much lower neutral rate than in past cycles.
- Still, rising rates are a headwind. Active management can help to mitigate it. As it stands, developed economies are in different stages of the cycle (Japan and Europe versus everybody else), and that is fuelling policy divergence, which will create discrepancies in relative valuations in a global context. That provides an opportunity for risk diversification, particularly in credit.
- The shape of emerging markets is also different this time. We believe the drivers of global growth are shifting away from the U.S. to developing countries in aggregate, but more specifically China. Most of the emerging markets depend on its growth profile, and that bodes well for opportunities there. EM portfolio exposure contributes to risk factor diversification, viz-a-viz inflation related to commodities and China.
Like central banks, investors should keep their options open. Market complacency, evidenced by the relative richness of risky assets, is a clear and present danger. Goldilocks moments like this don’t last forever – they’re part of the cycle, after all. As those of us old enough to remember 2007 will recall, the last one didn’t end so well.