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How 'spooked' investors are fleeing to government bonds as stocks suffer

North American equity markets plunged further into correction territory on Wednesday after weaker-than-expected U.S. retail sales numbers and a disappointing start to earnings season prompted investors to seek safety in government bonds

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North American equity markets plunged further into correction territory on Wednesday after weaker-than-expected U.S. retail sales numbers and a disappointing start to earnings season prompted investors to seek safety in government bonds.

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The TSX fell further into correction territory, losing 12% since the record highs of last month and getting close to shedding all its gains for the year


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The S&P/TSX composite index fell 166.8 points, or 1.19%, to 13,869.88 while the Dow Jones Industrial Average declined 1.06% and the S&P 500 dipped 0.81%.

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“We’re seeing a bit of the flight-to-quality effect,” said Andrew Torres, chief investment officer at Lawrence Park Capital Partners Ltd. in Toronto. “Investors are clearly spooked by the price action in equities and they’re finding that the only safe-haven asset right now is government bonds.”

But he questions whether government debt makes a good core holding given how low yields are, especially since U.S. inflation is still running in the 1.5% to 2% range.

“We do like the corporate bond market here, even if government yields have reached an absolute low, because the pick-up you can get is quite attractive,” Mr. Torres said.

There are a number of things going on right now that are causing the market to be a bit spooked

He highlighted the benefits of owning high-yield bonds that pay 6%, given the historically low corporate default rates, as well as investment-grade bonds that yield roughly 100 basis points above Canadian or U.S. government debt.

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U.S. 10-year treasuries traded below 2% on Wednesday for the first time since June 2013, as a bigger-than-forecast decline in U.S retail sales for September caused traders to bet against a rate hike from the U.S. Federal Reserve in 2015, despite the widespread belief that its quantitative-easing program will end later this month.

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Disappointing earnings from KeyCorp and Bank of America Corp. also contributed to weakness in U.S. stocks as the S&P 500 almost wiped out its gains for the year.

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The TSX selloff was broadly based, led by Canadian financials and industrials, and it is now down 11.3% from its Sept. 3 peak.

“There are a number of things going on right now that are causing the market to be a bit spooked,” said Mike MacBain, portfolio manager at East Coast Fund Management Inc. in Toronto.

“There is the crisis in the Middle East, what’s going on in Ukraine and how that’s impacting trade in Europe, the precipitous fall in oil prices that investors are interpreting as a deflationary sign, as well as low growth in Europe, Japan and China.”

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Elsewhere, gold continued to rally as futures for December delivery rose above US$1,240 per ounce, while the Chicago Board Options Exchange Volatility Index soared more than 20% to its highest level since December 2011. The VIX has gained approximately 70% this year.

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“Selling begets selling,” said Steven Isenberg, chief executive officer of M Partners Inc. in Toronto. “It’s been a good market, so people want to lock in some gains. And if there is going to be a bad market, it often happens in the fall.”

Government bonds can act as a counter to equities in such markets, but the Fed is still trying to find an opportunity to raise interest rates, which would hurt bond prices.

“It doesn’t make any sense to me that five-year bonds are trading lower than where the Fed presidents are predicting overnight rates will be at the end of next year,” Mr. MacBain said. “I think that’s a result of the flight to quality, which is a function of what’s happening in the equity market.”

U.S. five-year treasuries are yielding between 1.35% and 1.4%, but he noted that seven voting Fed board members pegged the funds rate at between 1.35% and 1.5% at the end of 2015.

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However, Mr. MacBain sees the logic in falling yields for longer-dated Canadian and U.S. government bonds, particularly given the deflationary pressures in Japan, China and Europe.

He noted that with Italian bonds yielding about 2.3%, Spanish bonds around 2.2% and German bunds near 0.8%, Canadian and U.S. government bonds are rightly trading around 2%.

Nonetheless, the manager thinks the market’s behaviour is typical of that seen in the back half of most business cycles. He noted that stocks tend to fall 10% to 15% during such times, bond markets outperform for two to four months, then investors realize things aren’t that bad.

“I think we’re three to six weeks away from the end of that correction, then you’ll see people start to look more at fundamentals in the economy, bond market and central bank actions,” Mr. MacBain said. “Interest rates should then start to rise and equity markets will likely climb too.”

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