Research Report: Measuring Growth

BY: Richard Croft
Rather than trying to dodge the inflation / recession raindrops let’s take a collective deep breath, step away from the forces of supply and demand that throw more curve balls than Sandy Koufax and focus on the output side of the economic equation. Where we can drill down on the tool that measures the collective well-being of a nation; Gross Domestic Production, or its’ acronym: GDP.


Last month we talked about the impediments confronting central banks in their cage match with inflation. Bankers are playing a never-ending game of whack-a-mole against the cogs in the consumer price index, that rise and fall like a six-prong teeter totter. Since bankers are not politicians they exist in a no-pain-no-gain world where any solution that wrestles inflation into submission involves the “R” word. The trick is to dispense enough pain to take the edge off the inflation trajectory while keeping the economy from descending into the recession rabbit hole.

Mastering the soft-landing two-step requires an exact strategy that unfortunately, is formed on a base of imprecise data. Like trying to teach a Pilates class with your hands tied! So rather than trying to dodge the inflation / recession raindrops let’s take a collective deep breath, step away from the forces of supply and demand that throw more curve balls than Sandy Koufax and focus on the output side of the economic equation. Where we can drill down on the tool that measures the collective well-being of a nation; Gross Domestic Production, or its’ acronym: GDP!

GDP is the rock star in the economic arena. It’s Mick Jagger belting out “I can’t get no… economic satisfaction!” Just as rock and roll was the soul of the Zoomer generation, GDP is the heartbeat of the modern economy. It is what makes economists, and their econometric models shake rattle and roll.

GDP is the quintessential measuring tape that determines the size of a nation’s biceps. Recognizing the quirkiness of GDP calculations as economists struggle to dissect reams of data using complex inputs and statistical metrics to make certain the result is as accurate as possible. But, in the end, GDP is not just numbers and decimal places, it is a populations ecstasy gauge that ebbs and flows on a foundation of unpredictable variables and unintended consequences.

Looking at the numbers, Canada’s real month over month GDP was flat in April, falling short of consensus expectations for a 0.2% growth. Production in goods-producing industries progressed 0.1% during the month, which was too little to offset the slowdown in the services sector.

According to National Bank Economics, there were “healthy gains in mining/quarrying/oil & gas extraction (+1.2%) and construction (+0.4%) [that] more than offset declines in agriculture (-0.8%) and manufacturing (-0.6%). The utilities sector, for its part, stalled in the month. On the services side, gains in arts/entertainment/recreation (+2.0%), accommodation/food services (+0.6%) and transportation (+0.4%) were fully offset by declines in management (-2.2%), wholesale trade (-1.4%) and public administration (-1.0%).”

Eleven of the twenty sectors that National Bank follows were higher during April (the latest available full dataset). Part of this weakness could be explained by strikes in the public sector. To that point, GDP excluding federal government output grew only 0.1%, which is well-below the level of the first quarter of 2023, when Canada’s GDP grew by 3.1%.

The modest performance in April reflected significant declines in the private sector, specifically management, wholesale trade and agriculture. Interestingly, some interest rate sensitive sectors outperformed, as activity in the housing market and non-residential construction rebounded.

Notes National Bank, “according to Statistics Canada, GDP rebounded rapidly in May (+0.4%), with increases in federal government public administration, the manufacturing and wholesale trade, the latter possibly ending a three-month streak of declines. Given this early estimate, and assuming a flat print in June, this would imply a 1.4% annualized increase in Q2 GDP, a moderation from Q1 but slightly above the Bank of Canada’s most recent forecast of a 1.0% increase.”

One could argue that strength, notably across the interest sensitive spectrum, is what made it possible for the Bank of Canada to raise rates by ¼% on Wednesday, July 12th. On the other hand, this economic growth must be set against the current demographic backdrop which is having a pronounced impact on the housing sector which continues to rise because of limited supply and outsized demand propelled by Canada’s aggressive immigration stance. It is a classic battle between a rock and a hard place with the Bank of Canada and economic tailwinds, interacting like two statues engaged in a staring contest.

If the twists and turns associated with the growth versus inflation outlook were not enough, consider the fact that softer employment and fading inflation after the last rate hike seems to imply that the current tightening cycle is having the desired effect on the economy (see the Bank of Canada second quarter 2023 Business Outlook Survey). Which is why we think the July 12th rate hike may be the last in this tightening cycle.

The challenge for investors and those who manage money is that we are operating in the whimsical realm of scenarios spun in different directions – where reality takes a vacation and absurdity becomes the tour guide. The idea that the July 12th rate hike may be the last is at best, tenuous. While we believe the ten rate hikes since March 2022 are having an impact, the economy continues to exhibit resilience.

Notably in the tight labour market, despite showing some cracks (overall hiring plans are moderating and wage demands have declined modestly), it may not be enough for the Bank of Canada to step aside. The issue is the 4.5% average expected wage increase that remains well above the 2010 to 2019 average of 2.9%, which is inconsistent with sustainable 2% inflation. Further, private enterprise surveys generally don’t see normal wage setting returning until sometime in 2025 or 2026. That is why our position is tenuous because there is a real possibility that the Bank of Canada will follow a better-more-than-less mantra, which raises the specter that there could be another hike in September.

Implications for the Financial Markets

While we share investor angst that things may get much worse before they get better, the objective is to formulate a probability-based strategy that avoids the warts on the economic landscape.

Take the financial sector as a case in point. Commercial banks have been the laggard among large cap equities. The question is should we sell because it is underperforming, or do we assess the impediments within the sector and ask if these challenges are permanent or transitory? We believe in the latter position because profit margins among the large banks are being impinged by an inverted yield curve that should normalize when this rate hiking cycle concludes.

More importantly, we anticipate a recovery in 2024, and history tells us that commercial banks typically lead an economic upswing. The other constructive factor is that we are being paid while we wait. Canadian banks are not only paying above average dividends, but they have also been increasing those payouts on a regular basis. As examples, consider Bank of Nova Scotia (currently yielding 6.307%) and CIBC (6.153%).

To this point the upbeat performance in the US stock market has been propelled by the “magnificent seven.” The mega-cap technology stocks (Meta Platforms, Apple, Microsoft, Nvidia, Alphabet, Tesla and Amazon) that are generally inflation resistant and are benefiting from the rise in artificial intelligence.

That gives rise to a couple of questions; 1) have the magnificent seven got ahead of themselves, or 2) will the rest of the market play catch-up? We believe that with a couple of exceptions (Nvidia and Tesla), the magnificent seven are not yet experiencing irrational exuberance and the underperforming sectors will become engaged as we get into the third and fourth quarter of 2023.

That said, we do not expect to see any revival among the laggards until market participants believe that interest rates have reached their terminal rate. Our base case is two more rate hikes by the US Federal Reserve and in a worst-case scenario, one more rate hike by the Bank of Canada, which should take place no later than September 2023. We do not expect any rate cuts in 2023, but that is of less importance, than a normalization of the yield curve.

And now for the caveat emptor. Our investment thesis hinges on the view that the impending recession will be closer to a soft landing than a splat on the economic pavement. In fact, we may already be experiencing a rolling recession which we will examine in our August commentary. For now, our approach to maintain our position in the large Canadian banks where the pay while you wait dividend flow, will act as a shield against a potential splat and produce above average price appreciation when the inevitable recovery takes hold.


Picture this: a labyrinth of cubicles stretching farther than the eye can see, abandoned meeting rooms haunted by the ghosts of PowerPoint presentations past, and filing cabinets that hold secrets you didn’t even know existed.

Commercial real estate landlords have become the business equivalent of empty nesters. The post pandemic return to work playbook that was supposed to unfold has simply not materialized. The benefits of working from home and collaborating with others via ZOOM or TEAMS meetings outweighed the costs and frustrations associated with commuting.

Employers who embraced the work from home strategy have, in many cases, discovered that employees were more productive and tended to work longer hours. That view was supported by a recent study by Statistics Canada where 90% of the work from home group reported being at least as productive at home as they were when working at the office. More than half (58%) reported accomplishing about the same amount of work per hour while roughly one third (32%) reported accomplishing more work per hour.

The work from home model is becoming embedded in corporate culture as can be seen in the language of negotiated labor contracts notably… in recent settlements between the Government of Canada and its labour unions. Look for more clauses in future labour negotiations as the desire to work from home is intensifying. Especially among Millennials who see the office as a place where hope comes to die, drowned by “creative” sit-downs with fellow workers that look more like a never-ending symphony of monotony, than an opportunity to participate meaningful change.

Like it or not, working from home is the new norm that will have negatively impact commercial landlords. We are already seeing the economic fallout as some owners of class A office buildings in New York and London are walking away from their investments. The landlords of downtown San Francisco’s largest mall have abandoned it. A new Hong Kong skyscraper is only a quarter leased. For lease signs are popping up in the largest Canadian cities.

This is a watershed moment for commercial real estate, and it will have an impact on the global economy. Despite the optimism of higher stock prices predicated on the view that the fastest interest rate increases in a generation will ebb, the problems for commercial real estate will be with us for years.

We are witnessing the dark side of capitalism propped up with cheap money. Developers financed massive investments in new office space and malls based on a mis-guided view about how people work, shop and live. As the cost of money “normalizes” developers are finding that their position at the thin edge of the wedge is untenable. A tipping point is coming!

In the US alone, US $1.4 trillion of commercial real estate loans are due this year and next, according to the Mortgage Bankers Association. When the deadline arrives, owners facing large principal payments may prefer to default instead of engaging in the game of Russian Roulette.

According to Bloomberg Business Week, “major institutional owners including Blackstone, Brookfield and Pimco have already chosen to stop payments on some buildings because they have better uses for their cash and resources.” That’s meaningful because institutional investors only give away assets that are severely underwater.

The rush to the exits has resulted in fewer transactions at lower price points. More so in the US where return-to-office rates have been lower than across Asia and Europe. Institutional quality office space in the US has plunged 27% since March 2022 since interest rates started rising. Apartment buildings have declined 21%, and malls are off 18%. As interest rate hysteria starts to take hold globally, expect the fallout in office values to ramp up. Before we see a trough, analysts expect a 25% decline across Europe and about 13% in the Asia-Pacific region.

Don’t expect any quick fixes. Considering it took six years for commercial real estate to recover after the 2008 financial crisis, it is likely that the current reset will take at least ten years to normalize.

And there are few options for distressed buildings. It is not as if developers can simply turn an office building into residential condominiums. Altering infrastructure to accommodate residential living is complicated. The sheer number of new bathrooms dramatically alters the impact on utilities.

The larger question is whether the downturn in commercial real estate will overwhelm the financial system, already reeling from the fallout among US regional banks. There is a real risk that a deepening downward spiral will have a transformational impact on major metropolitan areas. Not only in terms of the impact empty buildings have on the service sector in downtown cores, but also the gaping hole vacancies will have on property tax revenue.

The work from home model and the impact it has had on vacancy rates is a multifaceted issue that affects various stakeholders and has broader implications for the local and national economy. The ripple effect is significant as local businesses such as restaurants, cafes, and retail stores that rely on office workers, will ultimately experience a decline in customer traffic and revenue which in turn, can lead to job losses and reduced economic activity in the area. The upshot is that the downturn in commercial real estate will impact economic growth. The question is by how much?


In recent decades, the global economy has increasingly relied on advanced technologies such as smartphones, electric vehicles, renewable energy systems, and defense applications. At the core of these technologies lies a group of elements known as rare-earth minerals.

The classification is a bit of a misnomer, as they are not particularly rare in the Earth’s crust. What gives them value is that rare-earth minerals are difficult to extract and process. China, being one of the few countries to have mastered the extraction and processing techniques, is the dominant player in this space, which makes other technologically advanced countries heavily reliant on Chinese supplies.

China is blessed with an abundance of rare-earth minerals accounting for roughly 37% of the world’s known reserves. Combine that with a well-established mining infrastructure and top-quality processing capabilities, and China controls a staggering 80% to 90% of the global rare-earth minerals supply. This gives China considerable economic and geopolitical leverage, raising concerns among major industrialized powers about overreliance on a single source for these critical resources.

This dominance did not occur overnight. China’s journey to becoming the world’s leading rare-earth minerals powerhouse began in the 1980s when it strategically recognized the value of these elements for future technologies. The Chinese government implemented a comprehensive plan to consolidate its position in the industry by subsidizing rare-earth mining operations and making significant investments in research and development.

The Chinese Communist Party has been stockpiling rare-earth minerals with the same gusto that Gen Z’ers are hoarding “Pokémon Cards.” By establishing stringent export quotas, China can manage rare-earth exports much like OPEC does with oil and maintain control of the logistics through supply chain management.

This tells us that China’s dominance in rare-earth minerals is worth more in political capital than economic value. Geopolitically, it allows China to exert significant influence over global technological advancements and supply chains, with the potential to disrupt economies and industries that rely on these minerals. Furthermore, China’s control over rare-earth minerals has raised concerns about potential trade disputes, export restrictions, and the impact on national security for countries dependent on these resources for their defense capabilities.

That takes us to the China / US trade war over semiconductors that has been heating up since last October. It began when the Biden administration unveiled a set of export controls banning Chinese companies from buying advanced chips and chip-making equipment without a license.

Chips are vital for everything from smartphones and self-driving cars to advanced computing and weapons manufacturing. US officials decided to take this step to protect national security interests. Sensing that a standalone US initiative would not be sufficient, the Biden administration engaged with other suppliers in the Netherlands and Japan to enact similar protocols. These countries agreed to back the US which put enormous pressure on Chinese manufacturing industries.

China initially retaliated in April when the government launched a cybersecurity probe into Micron before banning the company from selling to Chinese companies working on key infrastructure projects. The second punch occurred on July 3rd when China imposed export controls on two strategic raw materials, gallium, and germanium.

Gallium is a soft, silvery metal and is easy to cut with a knife. It’s commonly used to produce compounds that are key materials in semiconductors and light-emitting diodes. Germanium is a hard, grayish-white and brittle metalloid that is used in the production of optical fibers that can transmit light and electronic data. The short version is that these metals are critical to the chipmaking industry.

Interestingly, gallium and germanium are usually formed as a byproduct of mining more common metals, primarily aluminum and zinc. What gives China clout in this by-product market is its’ economies of scale in mining and processing that have allowed it to be the low-cost producer in this market.

China is the world’s leading producer of both gallium and germanium, according to the US Geological Survey. The country accounted for 98% of the global production of gallium, and 68% of the refinery production of germanium.

The introduction of export controls in two specific metals has drawn comparisons with China’s reported attempts in early 2021 to restrict exports of rare earths that included a group of 17 elements. It is entirely possible that China will revisit that strategy over the next couple of months.

The West faces some challenges in the near term. But so does China! The promise of reliable low-cost products delivered through secure supply chains is less credible when China takes a tough stance in a trade war with the US. Cutting off supplies short-circuits the reliability message which feels a lot like deleting an entire hard drive to remove a single file.

Export restrictions will constrain the West in the short term. But longer term, there is hope that Australia’s rare-earth producers will become more sophisticated providing a formidable alternative to Chinese supplies.


Portfolio managers spend a lot of time trying to mitigate the ups and downs in financial markets. When building portfolios, we look for something a little more “bonding” so that fluctuations in valuation feel more like gentle swings in a hammock than the hair-raising oscillations of a roller coaster.

Easier said than done! Just ask the investors who bought mortgage back securities during the financial crisis because they were marketed as a tranquil oasis in a chaotic financial world. A way to relax and say goodbye to those sleepless nights filled with stock ticker nightmares. In the end, the complex world of securitization with regulators asleep at the switch, left uninformed investors with lighter pocketbooks.

Last year’s sell-off across every asset class punched another hole in the bond markets so called safe-haven dyke. Nothing like a broad-based sell-off where Canadian bonds (as measured by the iShares Core Canadian Universe Bond Index ETF symbol XBB) declined by 11.67%, to raise the hairs on one’s back!

Caveats aside, a bonds’ steady income stream and relative stability in the right environment makes fixed income investing the closest thing investors have to a BFF (Best Friend For life).

Key to this discussion is making sure we are in the right environment. The period from the beginning of the pandemic through to the end of 2022 was clearly not the right environment. With interest rates at or near zero, fixed income securities had nowhere to go but down. Which is what happened when central banks began raising interest rates. However, with 18 months of rate hikes behind us, we are closer to the end of the rate hiking cycle than to the beginning. And while we do not expect any rate cuts in 2023, a slowing economy may well trigger rate cuts in 2024. Bottom line, this is an excellent environment for short-term bonds with one-to-four-year maturities, not only in terms of the ballast they provide within a portfolio, but with some upside potential should the direction of rates change.

Given the BFF analogy you might think that investing in bonds is as close as you can get to a sure thing. Not quite! The fixed income market is sophisticated and generally trades over the counter. As such, it is important to have access to a bond desk with sizeable inventories and significant broker connections.

It is also a market with its own nomenclature, like passwords to gain entry in a secret club. Terms like coupon rate, term to maturity, current yield and yield to maturity are things to consider when making an investment in fixed income securities. It is with that in mind that we felt it helpful to provide a fixed income primer. So, buckle up (or maybe not) as we take a ride through the bond market labyrinth.

Understanding Fixed Income Investments:

Fixed income investments are debt securities issued by governments, municipalities, corporations, and other entities to raise capital. When investors purchase these securities, they are essentially lending money to the issuer in exchange for regular interest payments and the return of the principal amount at maturity. The primary objective of fixed income investing is to generate consistent income while minimizing the risk of default.

Several institutions issue bonds including the following:

  • Government Bonds: These bonds are issued by national governments and are considered to be among the safest fixed-income investments. They include Treasury bonds in the United States, government bonds in other countries, and sovereign debt issued by international entities.
  • Corporate Bonds: These bonds are issued by corporations to raise funds for various purposes, such as expansion, acquisitions, or refinancing. Corporate bonds offer higher yields compared to government bonds but also come with a higher risk of default.
  • Provincial and Municipal Bonds: Issued by Provinces and local governments, these bonds typically finance infrastructure projects, schools, and other public initiatives.
  • Asset-Backed Securities: These securities are backed by pools of assets, such as mortgages, auto loans, or credit card receivables. They offer exposure to specific underlying assets and while higher risk than traditional bonds can provide diversification benefits to investors.
  • Guaranteed Investment Certificates (GICs): GICs are time deposits offered by banks and other financial institutions. They offer a fixed interest rate for a specified period, ranging from a few months to several years. GICs are considered low-risk investments, and the principal is typically insured by the Canadian Deposit Insurance Corporation (CDIC).

Considerations for Fixed Income Investors:

Because the issuers of debt – government agencies and institutions – vary, portfolio managers must review several elements that impact the quality of the investment relative to the cash flow promised by the issuer. We examine several factors before deciding to buy a particular debt instrument including the following:

  • Credit Quality: Assessing the creditworthiness of issuers is crucial in fixed income investing. Credit ratings assigned by rating agencies provide an indication of the issuer’s ability to meet its debt obligations. Higher-rated securities generally offer lower yields but carry lower default risk.
  • Yield and Interest Rate Risk: The yield on fixed-income investments is determined by the prevailing interest rates in the market. Investors should consider the impact of changing interest rates on their investments. When interest rates rise, the value of existing fixed-income securities typically decline, while falling rates can lead to capital appreciation.
  • Maturity and Duration: Maturity refers to the time until the principal amount is repaid. Shorter-term bonds have lower interest rate risk but may offer lower yields. Duration measures the sensitivity of a fixed-income security to changes in interest rates. Higher durations indicate greater price volatility.
  • Liquidity: Consider the liquidity of fixed-income investments, as it impacts the ease of buying or selling securities in the secondary market. Highly liquid securities are easier to trade, while less liquid investments may carry a higher risk of limited market access.

Understanding Bond Pricing

The principal consideration is to recognize that a bond’s price is dictated by interest rates. Think of a bond’s price and the direction of interest rates as two friends sitting at opposite ends of a teeter totter. When interest rates are rising, bond prices fall, which is exactly what happened in 2022. Conversely, when rates are falling the price of the bond will rise. The trick is to engage in the bond market when rates are expected to decline.

How much a bond’s price will change based on the movement in short term interest rates is generally dictated by the bond’s term to maturity. The longer the term to maturity (the point at which the bond matures, and the investor receives their principal) the more dramatic the impact a move in interest rates will have on the bond’s price.

The Principal or Par Value that an investor receives at maturity is referred to as the bond’s Face Value. The Coupon Rate is the fixed amount the issuer promises to pay on a regular basis (usually interest is paid semi-annually), which is set as a percentage of the bond’s face value. These two factors establish the baseline for the bond’s cash flows.

A bond’s yield is calculated as a percentage of the coupon divided by the bond’s market price. The market price will fluctuate between the time of purchase and maturity. At maturity the coupon rate and the bond’s price converge at the bond’s face value. Prior to maturity, the bond’s price and its impact on yield is determined by several factors such as prevailing interest rates, the creditworthiness of the issuer, and the time remaining until maturity.

Valuing A Bond

Bond valuation involves calculating the present value of all expected cash flows associated with the bond, including periodic coupon payments and the principal repayment at maturity. This valuation is based on the prevailing market yield. The present value is calculated by discounting future cash flows using the yield to maturity (YTM) or yield to call (YTC), depending on the bond’s features.

The present value calculation is referred to as the bond’s duration stated in years. Duration helps the portfolio manager determine the sensitivity of a bond’s price to a change in interest rates. For example, the price of a bond with say, a duration of 2 years, would be expected to rise or fall by 2% based on a 1% change in the level of short-term interest rates.

Another factor when building our asset mixes, is to look at the convexity associated with a bond portfolio. Convexity supplements duration when determining the impact short-term interest rates have on the bond’s price. Convexity gauges the magnitude and direction of a bond’s price when interest rates fluctuate. Specifically, convexity captures the curvature of the price-yield relationship and accounts for the non-linear nature of bond price changes.

Positive convexity implies that bond prices increase to a greater extent when interest rates decline compared to the price decrease when rates rise. Negative convexity suggests that bond prices may not rise as much as they would decline when interest rates change. A bond with a call feature (e.g., where the issuer has the right to buy back the bonds prior to maturity) tends to exhibit negative convexity, as they have limited upside potential when interest rates decline due to potential early redemption.

Recognizing the influences that can impact the magnitude and direction of a bond’s price are crucial when buying fixed income securities. The interplay between face value, coupon rate, yield, and market price form the basis of bond pricing. When portfolio managers are looking to add fixed income assets to a portfolio, they evaluate the factors that impact a bond’s price and weigh the potential risks and rewards, with the objective of maximizing the performance and stability within the portfolio.

Richard Croft, Chairman & CIO

related posts

MACRO-ECONOMIC RESEARCH – An Option Primer                                                                                                                                          
MACRO-ECONOMIC RESEARCH – An Option Primer                                                                                                                                          

MACRO-ECONOMIC RESEARCH – An Option Primer                                                                                                                                          

COVERED CALLS: A CLOSER LOOK AT THE STRATEGY’S HIDDEN COMPLEXITIES Picture this, while sitting in your kitchen...