By Rob Edel, CFA
HIGHLIGHTS THIS MONTH
- Global equity markets rally after Brexit scare.
- The Pound is unforgiving, actually strengthening the blow to the British economy.
- The U.S. adds jobs in hopes of “making America great again.”
- Even with stronger jobs and housing, GDP still disappoints.
- The Federal Reserve cautiously maintains a happy medium.
- Crafty CEOs vs. Arrant Analysts.
- Oil: The crude state below $40.
- Negative rates + Low returns = Golden opportunity.
- Japan might be on to something…
- Is it time to shake things up?
READ THIS MONTH’S COMMENTARY IN PDF FORMAT.
The NWM Portfolio
Returns for the NWM Core Portfolio increased a strong 2.3% for the month of July. The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships. Actual client returns will vary depending on specific client situations and asset mixes.
Interest rates were unexciting in July, with only a slight flattening in Canadian and U.S. yield curves worth noting. NWM Bond was up an equally humdrum 0.2%.
High yield bonds, on the other hand, were quite exciting, with NWM High Yield Bond up 3.0% in July. Gains were seen across the broad credit spectrum, but energy, metals, and mining have been the main market drivers year to date.
Global bonds were also strong in July with NWM Global Bond up 1.8%. Interest rates, currency, and credit spreads all contributed to performance last month.
The mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning +0.3 and +0.4% respectively in July. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.3% for NWM Primary Mortgage and 5.6% for NWM Balanced Mortgage. NWM Primary ended the month with cash of $14.3 million, or 8.9%. NWM Balanced ended the month with $34.2 million in cash, or 8.2%.
NWM Preferred Share was strong during the month of July, returning 3.5% but still lagging the BMO Laddered Preferred Share Index ETF which was up 4.26%. The difference in performance is attributed to our positions in retractables and floaters which underperformed the larger rate reset market. Secondly, during the last two weeks of the month, a strong bid emerged for low back-end spread rate resets.We have select positions in this portion of the market which should have strong price appreciation if the 5-year Bank of Canada yields pick up sharply; however, we are underweight versus the index as these preferred shares continue to be very volatile. One of the most attractive portions of the market continues to be new issuance. Brookfield Infrastructure issued a rate reset at 5.35%. We estimate this to be approximately 0.25% premium to where they could issue in a more normalized environment and as a result expect the shares to trade from $25 to $26 shortly after they hit the exchange.
Canadian equities were strong in July, with the S&P/TSX +3.9% (total return, including dividends), while NWM Canadian Equity Income and NWM Canadian Tactical High Income were up 4.3% and 3.4% respectively. Not bad, given neither fund holds any positions in gold, which continues to move higher. Lumber stocks had a good month, which helped NWM Canadian Equity Income. We trimmed our positions in Rogers and TransCanada given their recent strength, and added to our holdings in Manulife and Whitecap Resources. In NWM Canadian Tactical High Income Fund, we added a new short put position in Couche-Tard and Saputo, trimmed our holdings in KP Tissue, and sold our remaining stake in Diversified Royalty Corp.
Foreign equities were also strong in July with NWM Global Equity up 4.7% compared to a 5.0 increase in the MSCI All World Index and a 4.4% rise in the S&P 500 (all in Canadian dollar terms). Of our external managers, Edgepoint led the way +6.7%, followed by Pier 21 Carnegie +4.1%, BMO Asia Growth & Income +4.0%, Lazard Global +3.6, and Pier 21 Value Invest +3.4%. NWM U.S. Equity Income increased 3.9% in U.S. dollar terms and NWM U.S. Tactical High Income rose 3.1% versus a 3.7% increase in the S&P 500 (all in U.S. dollar terms).
In NWM U.S. Equity Income Fund, we added to our existing positions in Mohawk, Costco, Sherwin Williams, Newell, and Home Depot, and trimmed Microsoft. We also exited our remaining holding in Intel. As for NWM U.S. Tactical High Income, we wrote new naked put positions on Tractor Supply Company.
Real estate increased in July with NWM Real Estate up 2.0%.
NWM Alternative Strategies was up in July (these are estimates and can’t be confirmed until later in the month). All our managers ended the month in positive territory. Of the Altegris feeder funds, Winton was up 1.7%, Brevan Howard +0.6%, Millenium +1.6%, and Citadel +3.5%. MAM Global Absolute Return Private Pool was +0.3%, RP Debt Opportunities +1.7%, Polar North Pole Multi-Strategy +2.0%, and RBC Multi-Strategy Trust +1.8%. Precious metals had another strong month, with NWM Precious Metals +10.4% and gold bullion up 3.1% in Canadian dollar terms.
July In Review
The negative impact of Brexit (Britain leaving the EU) appeared to be short lived as global equity markets rallied in July. In the U.S., the S&P 500 was up nearly 3.7% last month while our Canadian S&P/TSX more than kept pace, rising over 3.9%. International markets were also strong, with the STOXX Europe 600 gaining 3.7% and Japan’s Nikkei up nearly 6.4%. China also recorded a strong month, with the Shanghai Composite gaining 2.7% (all returns in local currency terms).
Bond yields reflected this investor optimism, with yield curves steepening as longer term yields increased and prices declined. Bonds are typically seen as a safe haven asset such that prices decline in times of uncertainty. Because short term bond yields are being artificially anchored around zero percent by central banks, any back up in yields tends to steepen the yield curve. This is not necessarily good for bond investors, but is a sign that traders are willing to take more risk. It could also signal a greater willingness by the Federal Reserve to raise interest rates again, as the odds of an increase in the Fed Funds Rate in 2016 increased to nearly 50% after plunging to under 10% after the British EU referendum.
Strangely gold, which is considered a safe haven asset and spiked higher after the Brexit vote, did not sell off leaving bullion prices remaining strong. Higher interest rates and a strong U.S. dollar are normally bad for gold, so the fact the recent bullion rally has remained intact is unusual. Or is it?
The risks of Brexit to the global economy were likely overstated by the market’s reaction last month. It’s bad news, but mainly for the British economy as even just the uncertainty over Brexit will have a negative impact on economic growth in Britain as consumer and businesses delay spending plans. The British Pound rightly declined over 8% right after the referendum and another 5% the following two weeks, and then it started to rally. This is not what the Bank of England was expecting, or wanted.
A weak currency helps soften the economic blow of whatever economic fate awaits the British Isles and serves as a bit of an insurance policy. A strong currency does the opposite. As a result, the Bank of England lowered interest rates 25 basis points in early August to the lowest level in the Bank’s 322 year history and re-instituted their dormant bond-buying program by promising to purchase £60 billion Gilts (British government bonds) and £10 billion corporate bonds over the next 18 months.
So that’s it then? The markets only concern was Brexit, and Britain has dealt with it? Not quite. Terror attacks in France and Germany and an attempted coup in Turkey seem to have been largely forgotten by the market last month, though apparently not by gold. Volatility, as measured by the VIX, has fallen close to all-time low levels, indicating markets are fairly complacent right now. While we concede there is some good news in regards to the Chinese and U.S. economy (reviewed below), we also think there are some things for investors to be concerned about, namely valuations, earnings, oil, and Japan.
First, the good news. China’s economy looks like it has stabilized, with second quarter GDP growth coming in at 6.7%. In addition, capital flows out of the Yuan appear to be contained with China’s $3.2 trillion foreign exchange reserves unchanged since February. Stability comes at a price, however, as reform and restructuring initiatives appear to be put on hold, and fiscal stimulus likely the major factor behind China’s economic growth remaining on target. This could provide problems down the road as China’s economy continues to depend on investment and an over supplied industrial sector rather than consumer spending. For now, however, China is just one less geopolitical risk to worry about. We’ll just kick that Chinese can down the road shall we?
Next up on the “good” side of the ledger is the U.S. economy. Fears that employment growth had peaked after May’s disappointing job report were put to rest last month with the U.S. adding a strong 255,000 new jobs on top of the upwardly revised 292,000 added in June. Even better, wage growth finally looks to be gaining traction, particularly for low wage workers. Given consumer spending is nearly 70% of the U.S. economy, jobs and higher wages will go a long way to “making America great again.”
Housing is also a big driver for the U.S. economy given the number of industries and jobs it indirectly impacts. While the recovery has been slower than we would have liked, new and existing home sales continue to move in the right direction. In June, just over 1 million new homes were under construction in the U.S., the highest level since February 2008, and existing homes changed hands at a pace not seen since February 2007.
One might expect with the strength in the job market, and a continued recovery in the housing, GDP in the second quarter would grow above trend but unfortunately this was not the case. The economy recorded an anemic 1.2% growth rate in the recent quarter ending in June, barely beating the first quarter’s 1.1% growth rate and just matching that of the lowly Euro-zone.
Consumer spending, which grew 4.2% and contributed 2.8% to GDP growth, was fine. Even net exports had a positive contribution. A drawdown in inventories was the biggest source of weakness, and hopefully should reverse next quarter as manufacturers replenish their stocks. Most manufacturing indices were in positive territory in July, indicating a growing industrial economy. Business investment also disappointed, and could prove more stubborn in turning around. Companies have been reluctant to spend money and invest during the economic recovery. Along with low productivity (which is likely related to low business investment), it’s one of the reasons average GDP growth has seen the slowest recovery in the post-World War II war era since the great recession.
It’s also been one of the longest as well; largely due to the fact that the Federal Reserve has maintained a very stimulant monetary policy with interest rates at extraordinarily low levels. Sluggish but positive, economic growth could extend the current economic cycle much longer than might ordinarily be expected. Not too hot, and not too cold, even Goldilocks would approve. It’s one of the reasons many strategists aren’t as concerned about the current high equity valuation of the market.
Stocks are expensive relative to historical averages, but not when compared to interest rates and inflation. In fact, according to Federal Reserve model, the market’s earnings yield, which is effectively the inverse of its P/E multiple, should equal 10-year bond yields. With 10-year U.S. Treasury’s yielding only 1.5%, this would mean the S&P 500 should trade at over a 66 price to earnings multiple versus its current level of around 18.
Low bond yields are also drawing investors into stocks with higher dividend yields, like utility and telecom companies, driving valuations in these sectors to even higher levels. Are these stocks vulnerable if interest rates start moving higher? Of course they are. But let’s kick that can down the road a bit as well.
Ok, now for some of the bad news. Slow economic growth may be good for valuations, but not so much for corporate earnings. Longer term, for stocks to work you need both. As of early August with just over 70% of S&P 500 companies having reported second quarter earnings, Thomson Reuters is forecasting negative year over year earnings growth for the fourth quarter in a row, down 2.6%. Even excluding energy, which they have pegged to notch an 87% decline, earnings are still only expected to rise 1.8%. Thomson Reuters isn’t expecting a big turnaround in the third quarter either, forecasting an increase of only 0.3%, down from expectations of 2% growth only a month ago. Profit margins are a big part of the problem, as stronger wage growth and the inability of companies to increase prices are hurting corporate bottom lines. Revenues haven’t helped much, however, with Thomson Reuters forecasting top line sales in Q3 will fall for the six straight month, declining 0.4% compared to last year.
What is interesting about earnings is that most traders and analysts likely don’t know or believe they are under pressure because companies know how to play the game. CEO’s are crafty and know how to guide analyst expectations down so when earnings are released, they rarely disappoint. It’s not unusual for a company to report negative year over year earnings growth but have their stocks price pop higher if earnings still come in higher than expected. While analysts may be slow off the mark, they do catch on eventually and thus tend to gravitate towards companies that really are growing. It’s one of the reasons growth stocks have continued to outperform value stocks during the slow growth economic recovery. When growth is scarce, as is the case now, investors are willing to pay more for it. In a robust economy, with strong economic growth, a rising tide lifts all boats, even cheap companies with crafty CEO’s.
Declining earnings isn’t the only thing the market appears unwilling to believe or notice. Stock prices have been rallying, despite the fact that the rally in crude oil prices reversed last month as WTI Crude Futures broke below $40 a barrel again in early August and threatened to enter bear market territory, down more than 20% from levels seen in early June.
I know, lower oil should be a good thing for the U.S. economy and thus the market, but this hasn’t been the case recently. The correlation between oil and the S&P 500 reached 0.97 earlier in the year, meaning they were nearly perfectly correlated. Oil was collapsing and traders were concerned it would take the economy and stocks down with it. While the correlation between oil and stocks have declined lately, there is still some concern that if oil continues to flounder and tests its recent lows, stocks and high yield bonds could go down as well. We are not sure this is the case given the energy sector has already been downsized and any further decline wouldn’t have as big an impact on economic growth. Also, oil prices do have to normalize around $50 to $70 a barrel at some point in order to justify developing new supply.
While the market may still be over supplied right now, future demand growth and natural decline rates will require new oil projects to come on stream in the future. Canadian production coming back on line after the Fort McMurray fires, as well as a recovery in Nigerian and Libyan production (which due to geopolitical reasons might be temporary) caused an increase in supply last month, as did higher production from Saudi Arabia and Iran. It is unlikely the Saudis have much spare capacity left and supply growth should be more constrained going forward.
Same for U.S. shale oil producers. While the U.S. rig count has recently begun to move higher, the fall in crude below $40 a barrel will help curtail future increases. We don’t think oil will be as big a threat to the market as it has been, even if crude does trade lower in the short term.
Japan maybe a different story. We continue to keep our eye on Japan, not because we think the fate of the Japanese economy will have a big impact of what happens in Canada and the U.S., but because we view events in Japan, or more specifically Japan’s future fiscal and monetary policy plans, as a potential preview to what might unfold in other countries.
The central banks of the United States, the United Kingdom, and the Euro-zone have all cut interest to zero (or close to it) and have increased money supply by printing money and buying government debt (quantitative easing). So has the bank of Japan, but they have taken the business of money printing to a whole new level, presently owning more than a third of all outstanding Japanese government bonds and on track to increasing their stake to 50% by 2018. In addition, the Bank of Japan joined the negative interest rate club in January, cutting bank deposit rates to -0.10%, which helped drive bond yields into negative territory and resulted in 87% of all outstanding Japanese government bond yields trading below zero percent in July; but it’s not working.
Consumers aren’t spending more, and companies continued to horde cash. In fact, negative interest rates haven’t worked anywhere. Consumers in Germany, Denmark, Switzerland, and Sweden are also saving more, despite earning no return on their savings. Low returns mean consumers need to save more, not less, in order to meet their retirement needs. Negative rates also convey fear and an inability of the central bank to manage the economy, hardly the environment one wants to foster in order to entice consumers to open their wallet. Consumers borrow and spend when they are confident about the future. Negative interest rates smack of desperation, not confidence. Gold loves desperation, however. Nothing would push gold prices higher than if markets lose confidence in the world’s central banks.
Ok, so if monetary policy isn’t helping drive consumer spending, at least it’s helping drive down the Japanese yen, right? Nope, in fact the yen has been strengthening, which we admit is perplexing. Clearly the market is coming to the conclusion that monetary policy has outlived its usefulness, and it looks like the Japanese government is coming to the same conclusion. Rather than ramp up government bond purchases even more or driving interest rates down even further, Japan looks to be turning towards fiscal policy.
In early August, the Abe government announced a new ¥28 trillion yen fiscal stimulus program that included ¥7.5 trillion in new direct spending. A typical reaction to an increase in government spending should be an increase in interest rates, and for once, Japanese markets complied. 10-year Japanese government bond yields surged higher, trading at -0.29% before the announcement, but ending the day trading near zero percent.
Could this be a road map for European central banks, or even the U.S. Federal Reserve? Germany remains firmly against increased deficits, but they are increasingly an outlier. As for America, politicians appear to be softening their stance against increased deficits, with both presidential candidates including increased fiscal stimulus in their campaign platforms.
Falling deficits and lower interest rates have reduced the urgency of fiscal discipline, despite the fact the Congressional Budget Office now believes the national debt is on track to exceed total economic output by 2033, six years earlier than their forecast last year.
If the U.S. and Europe follow Japan’s lead and increase fiscal spending, will bond yields go up in these countries as well? And if they do, is this a bad thing? It is if they go up quickly, but a gradual increase might be a sign that the economy is getting stronger and give businesses the confidence to finally start investing. Low rates don’t seem to be helping the economy now. Maybe it’s time to try something different.
Don’t get us wrong, in the short term, higher interest rates would be bad for the market, both stock and bonds. Low interest rates, and the belief that the Fed is on hold for the immediate future, is one of the reasons we believe the market has been so resilient. We suspect, however, this trade is getting a little long in the tooth.
The market is underpricing the potential for the Fed to raise interest rates this year keeping in mind stock and bond prices are vulnerable if the Fed moves sooner than expected. We don’t expect a large increase in rates, but bonds are so over-bought that even a small increase could be a shock to the market. Volatility is very low, especially given the current geopolitical and economic environment. Trade with caution and heed the yellow metal’s warning.
What did you think of July’s economic activity? Let us know in the comments below!
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.
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