_{^{Q3 2024}}

Pension barometer

The Canadian bond market advanced in the second quarter as the Bank of Canada (BoC) lowered short-term interest rates in June, its first rate cut since March 2020. The BoC also signaled that more rate cuts were most likely forthcoming later in the year as economic activity and inflation continue to cool. Canadian economic growth in the first quarter of 2024 came in below forecasts, and other economic data released was generally weaker than anticipated. Meanwhile, the year-over-year inflation rate hit a three-year low, further paving the way for an interest-rate cut.

Over the second quarter, short-term Canadian bond yields declined, reflecting the rate cut, while intermediate- and longer-term bond yields were largely unchanged. Sector performance among Canadian bonds was uniformly positive, with high-yield and investment-grade corporate bonds posting the best returns, while provincial government bonds lagged.

Canada’s equity market traded sideways in a tight range through Q2 and closed with a narrow loss. Investor sentiment was dampened by slowing economic growth, even as a downtrend in inflation opened the door for the BoC’s rate cut. While precious metals mining stocks performed well, financials—the market’s largest sector—produced a negative return.

Global equities finished the second quarter with positive performance, as investor sentiment remained supported by stable global growth trends and healthy corporate earnings. The United States was a notable outperformer due in part to persistent strength in mega-cap technology stocks, which was spurred in part by continued excitement about the growth potential of artificial intelligence. Conversely, Canada lagged due to its heavier tilt toward value. Europe performed well overall, but stocks finished well off their midquarter highs following election results in France and other nations. In Asia, Japan was a notable underperformer in Canadian dollar terms due to pronounced weakness in the yen, while the emerging markets outpaced their developed-market peers following strong gains for China, India, and Taiwan.

Canada yield curve %

Source: Bank of Canada, Manulife Investment Management, as of June 30, 2024. 

The average funded status improved to 131.1% from 130.0% during Q2, driven by a modest drop in liabilities. Assets continued to outpace liabilities over the quarter, resulting in a healthier funded status. The current average funded status is significantly higher than what it was in December 2020. 

Funded status of the average defined benefit pension plan in Canada

Source: Moody’s Analytics PFaroe, as of June 30, 2024.

The average asset mix represents a combination of growth, hedging, and diversifying assets, each playing a unique role in the functioning of the pension portfolio. Based on Manulife’s capital market assumptions, the average asset mix implies an interest-rate hedge ratio of 53.7%, relative to the interest-rate exposure of the average liabilities² and an expected return of 6.16%. Based on Manulife’s modeling and stress testing, there’s a 95% probability that losses relative to liabilities will be less than 14.38%.

Equity risk represents a large component of risk exposure for defined benefit pension plans; therefore, a drastic downward move in equity prices has the potential to reduce a significant portion of the surplus for the average defined benefit pension plan in Canada. A decrease in interest rates also has the potential to negatively affect the surplus for the average defined benefit pension plan, as it would lead to an increase in present value of liabilities.

Sources of relative risk for the average defined benefit pension plan

The chart below illustrates sources of relative risk for the average defined benefit pension plan. As shown in the chart, a fair amount of risk is diversified away, and along with significant equity risk, the average pension plan also has exposure to interest-rate risk, credit risk, and property risk.

Source: Moody’s Analytics PFaroe, as of June 30, 2024. VaR refers to value at risk.

Solvency funded ratio

The chart below illustrates the solvency funded ratio of the average defined benefit pension plan across various scenarios, ranging from best case to worst case, forecast all the way out to 2032.

Based on our scenario analysis, the median forecast solvency funded ratio for the average defined benefit pension plan in June 2025 is 134.4%, and in June 2034, it’s 136.5%. 

Source: Manulife Investment Management, as of March 31, 2024.

In recent weeks, various measures of economic activity have receded from their peak levels and are normalizing to prepandemic levels. In a vacuum, this is the soft landing narrative that’s been the consensus prediction from market experts for much of 2024. However, the term normalizing currently means that economic measures are trending lower, or weakening, and given that economies tend to function off momentum, economic data could continue to trend lower without something stopping it.

The most likely catalyst to stall the negative economic momentum is the U.S. Federal Reserve (Fed) lowering interest rates. There have already been interest-rate cuts from the European Central Bank, the BoC, and the Swiss National Bank, among others, but the challenge for the Fed remains that inflation in the United States continues to be stickier than the rest of the world and remains above their long-term target. However, as economic data such as jobless claims, job openings, services activity, and manufacturing activity is all trending lower, our view is that the Fed will react to the downside risks and cut rates multiple times in 2024 and, importantly, will move toward their 3% target over the next 12 to 18 months. Overall, we remain positive in the near term but are alert to potential hidden market weakness.

From an asset allocation perspective, while we continue to favor equities over fixed income, this view has shifted toward neutral relative to our view last quarter. Corporate earnings growth has remained resilient amid a higher interest-rate environment; however, some economic data has softened, such as unemployment and GDP growth. Within equity, the United States remains the most resilient global market, underpinned by strong economic growth and corporate earnings. However, marginal improvements in earnings growth in other parts of the world combined with extended valuations within U.S. large-cap stocks have led us to moderate the size of this overweight. U.S. small caps and European equities are two areas of the market with valuation cushions that bear monitoring should rate cuts in the United States take place. Another key market to monitor is China, where our view on equities remains neutral, but that view is leaning more toward positive driven by attractive valuations and a stabilized economy.

Our view on corporate bond positioning remains cautious. With credit spreads at near-historic tight levels relative to government bonds, there’s limited further upside potential from spread tightening. At the same time, minimal spread widening could wipe out the yield advantage, particularly in investment grade. Emerging-market bonds remain an attractive option given favorable fundamentals and wider spreads relative to U.S. high yield in particular, while leveraged loans also offer favorable spreads and yield and have already cleared the challenges of higher short-term rates.

Finally, as the outlook for equity markets remains uncertain, alternative investments such as real assets offer an attractive third asset allocation lever to help navigate challenging markets where appropriate.

1 Asset mix assumptions. 2 Liability assumptions.

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