When it comes to interest rates, you can’t get more different than what’s happening in the U.S. and Canada. Stateside, we anticipate up to three more rate increases this year as the already healthy U.S. economy gets a procyclical boost with U.S. tax reform and fiscal stimulus. In contrast, since last fall, economic activity in Canada has decelerated, leading to a more cautious normalization path from the Bank of Canada.
What does this mean for investors? For starters, holding some Canadian duration makes sense because we don’t see Canadian rates coming under as much pressure as in the U.S. Strategically, credit exposure can provide attractive potential income, though at this point in the cycle some caution is warranted. While we still believe the global expansion has room to run, we’re also actively monitoring early signs of potential overheating in the late cycle environment.
When it comes to valuations, U.S. and emerging market credit spreads reached post-crisis tights in late 2017, reflecting low default risks against a backdrop of solid global growth. Since then, we’ve seen a modest widening in spreads as investor sentiment shifted and volatility picked up amidst U.S. trade policy uncertainty and building geopolitical tensions.
Rising volatility and rising interest rates are typically associated with higher risk premia. Despite the recent moves, spreads remain tight compared to historical levels. In fact, credit spreads in many markets are trading at the lowest levels as a percentage of their overall yield in a decade (see chart below). With the potential for additional volatility and rate rises on the horizon, credit assets are less attractive at these levels. That’s why we recently reduced exposure to credit risk in our iShares strategic income portfolios. Looking forward, if spread levels widen again, we’ll look to adjust accordingly. For more on our strategic income portfolios, check out the fixed income section on our site.