December 2016: A Strong Close to An Eventful Year

By Rob Edel, CFA

Highlights This Month

• Global events threw a wrench into predictions throughout 2016.
• Early speculation on the Trump Administration’s impact on markets.
• Consumer confidence is high – will corporates follow suit?
• U.S. Corporate Tax Reform: Our Summary.
• The U.S. Federal Reserve practice caution during transition.
• China is in dangerous territory and Trump isn’t helping.
• Equities rally and interest rates rebound on hope alone.
• Adaptability will be key in 2017.

Read this month’s commentary in PDF format.

The NWM Portfolio

Returns for the NWM Core Portfolio Fund increased 1.2% for the month of December and 9.4% for 2016.  The fund 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.

The Canadian yield curve steepened again with 10-year yields backing up 14 basis points to 1.71% in December.  U.S. 10-year yields backed up 6 basis points, almost the same as 2-year yields.  Despite the back up in yields, our managers performed well, with the NWM Bond Fund up 1.2% for the month, and a very respectable 5.3% for 2016.  ArrowCapital’s East Coast Investment Grade Income Fund continues to perform strongly in this environment and was up 1.2% in December and +15.0% year to date.  Marret Investment Grade Hedged Strategies Fund has also performed well, up 0.7% last month and 7.9% for the year.

High yield bonds also performed well as credit spreads continued to narrow in December.  The NWM High Yield Bond Fund was +1.8% in last month and + 13.2% for 2016.

Despite a strong U.S. dollar, global bonds performed well in December with the NWM Global Bond Fund up 1.6% for the month, but only +1.2% for the year.

NWM mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.3 and +0.4% respectively in December.  For 2016 in total, NWM Primary Mortgage Fund was up 3.7% and NWM Balanced Mortgage Fund was +5.3%.  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 4.2% for NWM Primary Mortgage Fund and 5.3% for NWM Balanced Mortgage Fund.  NWM Primary Mortgage Fund ended the month with cash of $22.5 million, or 14.4%.  NWM Balanced Mortgage Fund ended the month with $58.3 million in cash, or 12.7%.

The NWM Preferred Share Fund was up 4.2% for the month of December while the BMO Laddered Preferred Share Index ETF returned 4.8%. In a year where volatility dominated headlines, a rally into year-end helped the market with rate resets returning 6.8% for the year while the NWM Preferred Share Fund was up 8.4%.  Even though 5-year Government of Canada yields continued to grind higher from 1.01% to 1.11%, strong money flows into preferred shares also contributed to the month’s impressive return. Demand for preferred shares came in the form of both ETF buying and structured principal at risk notes.

Canadian equities were positive in December, with the S&P/TSX up 1.7% (total return, including dividends) for the month and 21.1% for 2016 in total.  The NWM Canadian Equity Income Fund and the NWM Canadian Tactical High Income Fund gained 1.1% and 1.5% respectively for December, with 18.7% and 14.9% for 2016.  Being underweight in energy hurt relative performance in both funds in December, while not owning any gold or base metal positions detracted from overall returns in 2016.

Strong market returns are difficult to track for option writing strategies given upside movements in price are capped.  This was particularly relevant for the NWM Canadian Tactical High Income Fund given the low current delta and high naked put and covered call positions in the portfolio.  In the NWM Canadian Equity Income Fund, we initiated a new position in CGI Group and added to existing positions in Manulife, Royal Bank, Intact, Sun Life, and TD Bank.  We sold Ag Growth, Brookfield Business Partners, Brookfield Property Partners, and IGM Financial.  In the NWM Canadian Tactical High Income Fund, we added a new naked put position in Empire Company.

Foreign equities were stronger in December with the NWM Global Equity Fund up 1.0% compared to a 2.7% increase in the MSCI All World Index and a 2.0% rise in the S&P 500 (all in Canadian dollar terms).  For 2016, the NWM Global Equity Fund was +1.1% versus +5.2% for the MSCI All World Index and +8.9% for the S&P 500.  The results from our external managers were mixed last month.  Pier 21 Value Invest led the way +2.5%, followed by Lazard Global +1.6%, Edgepoint +1.4%, Pier 21 Carnegie +0.7% and BMO Asia Growth & Income -2.3%.  For 2016 in total, Edgepoint was the stand out, increasing 15.8%, followed by Pier 21 Value Invest +2.6%, while BMO Asia Growth & Income was -0.3%, Lazard Global -0.7%, and Pier 21 Carnegie -7.4%.

NWM U.S. Equity Income Fund increased 1.7% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.1% versus a 2.0% increase in the S&P 500 (all in U.S. dollar terms).  For 2016 in total, the NWM U.S. Equity Income Fund increased 8.5% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 13.1% versus a 12.0% increase in the S&P 500 (all in U.S. dollar terms). In the NWM U.S. Equity Income Fund, we established a position in U.S. Bancorp and Anadarko, trimmed our position in Citigroup, and sold our entire position in Exxon Mobil.  No new positions were added in the NWM U.S. Tactical High Income Fund.

Real estate increased in December with the NWM Real Estate Fund up 1.4% versus the iShare REIT index +3.7%.  For 2016, the fund was +10.3% versus the iShare REIT index +16.8%.

NWM Alternative Strategies Fund was up 1.1% in December (these are estimates and can’t be confirmed until later in the month) and +3.6% for 2016.  All our Altegris feeder funds had positive returns in December, with Citadel +1.8%, Winton +1.4%, Brevan Howard +1.1%, and Millenium +0.6%.  For 2016, Brevan Howard and Citadel were up +1.6% and 0.9% respectively while Millenium and Winton were -0.5% and -4.9%.  All our other alternative managers were also up in December, with MAM Global Absolute Return Private Pool +2.2%, Polar North Pole Multi-Strategy +1.2%, RBC Multi-Strategy Trust +1.1%, and RP Debt Opportunities +0.8%.  For 2016, only  MAM Global Absolute Return Private Pool finished the year in negative territory with a -1.4% return, while Polar North Pole Multi-Strategy increased 14.9%, RP Debt Opportunities was +11.1%,  and RBC Multi-Strategy Trust returned +10.4%.

Precious metals ended the year on a weak note, with the NWM Precious Metals Fund -0.6% and gold bullion down 1.4% in Canadian dollar terms, but for 2016 in total the NWM Precious Metals Fund increased 42.9% with gold bullion up 5.0%. 

December in Review

Equity markets ended the year on a strong note, with the S&P/TSX Index up 1.7% in December and just over 21% for 2016 in total while U.S. markets gained 2% last month to finish the year up 12%. All’s well that ends well, we guess, but the final numbers don’t fairly represent what played out as four different phases for markets last year.

Up until mid-February, investors were concerned that economic growth in the U.S. was stalling as job growth appeared to be losing steam.  As a result, equities sold off and bond yields declined (bond prices moved higher).  As the economy appeared to stabilize, stock prices rallied, but the gains were driven by dividend-paying defensive names as investors searched for yield alternatives to bonds, whose yields continued to sink to absurdly low levels.

Starting around mid-year, stocks became range bound as bond yields gradually moved higher.  Investor angst over the efficacy of central bank monetary policy and uncertainty over the November 8^th U.S. Presidential election weighed on investor confidence.  After the election, well you know the rest, stocks and bond yields both moved higher.

It was a tough market to get right last year.  Most investors entered 2016 thinking stocks were going to be the place to be, only to be disappointed early in the year as recession fears, both domestic and international, put pressure on equities and lifted bond returns.  In June, when the U.K. surprised everyone and voted to leave the EU, most strategists wrongly predicted a market meltdown.  Stocks did turn lower initially, but quickly recovered their losses.

The same went for the U.S. election.  Few predicted a Trump victory and many believed markets would plummet if he won. Both proved incorrect.  Case in point, it is rumored George Soros’ bearish post-election bets cost the famous hedge fund investor $1 billion, which is roughly what he made betting against the British Pound in 1992.

Perhaps the most intriguing aspect of the last year’s events is the stage it sets for this year.  The U.S. economy may have started 2016 on a weak note, but it gained momentum as the year progressed.  Can this positive momentum be maintained?

While Trump can’t take credit for the improving economy, he can rightfully claim his election victory has helped boost investor confidence, particularly with white Republican investors. The risk for the market, however, is whether this confidence is justified.

How successful will the Republican’s be in implementing their policies, and will they actually work as promised and drive economic growth higher?  Repealing and replacing Obamacare and corporate tax reform top the list of initiatives traders will be watching closely in 2017.  Also sure to get close scrutiny will be the U.S. dollar and its impact on other global economies like China, along with what path the Federal Reserve takes in regards to normalizing monetary policy.  Of course, how the new administration deals with the geopolitical legacy left by the Obama administration could, pardon the pun, Trump them all.  Despite some potential positive catalysts, equity markets appear inflated and it’s hard to predict what Trump will do.

Perhaps the biggest good news story in 2016 was U.S. job market, as the U.S. economy created more new jobs than it has lost for 75th straight month in December, a record dating back to 1939.  While the 2.2 million new jobs created for 2016 in total was the smallest annual gain since 2011, one could argue America is nearing full employment given the unemployment rate is a mere 4.7%. The only thing missing has been wage growth, which finally showed signs of kicking into gear in December, increasing 2.9%.

In-line with a robust job market, consumer spending and housing continue to firm, with consumer confidence hitting a 15-year high in December.  In order to move to the next level and become more sustainable, however, capital spending needs to accelerate.  U.S. companies have been reluctant to spend money given sluggish global economic growth and low inflation.  According to Bloomberg, this could be about to change, as analyst expectations for capital expenditures 12 months forward have rebounded dramatically since the election.

Business leaders hope the Republican administration will prove more business-friendly by lowering taxes, reducing regulatory and environmental burdens, and increasing infrastructure spending.  Given the recent rally in crude oil prices, the energy industry could be a prime recipient for increased investment flows.  After all, it was only a couple of years ago when technological advances in drilling technology spurred a huge flood of capital investment into the sector and helped re-invigorate the U.S. industrial economy.

The energy sector doesn’t necessarily need Trump to successfully pass infrastructure, environmental, or regulatory legislation in order to be successful in 2017, and neither does the U.S. economy in general.  It was firming before Trump was elected and should continue to improve at a slow and steady pace.  But can Trump help accelerate up even more?  Yes, though we are less optimistic than the market on how successful he will be.

As we explained last month, infrastructure spending sees slow implementation and it is debatable how much it can add to growth.  Anti-trade and immigration initiatives would actually be counter-productive, in our opinion, and could hurt growth. Corporate tax reform, however, is likely to be the major domestic policy initiative for the Republicans in 2017 and where we see the biggest potential positive catalyst for the economy.

The House Republicans, led by Speaker Paul Ryan, are proposing some significant changes to the way U.S. corporations are taxed.  We hesitate to go into the details, because quite frankly they are likely to change several times before the Senate and President Trump sign off, but their significance is such that we feel compelled to give a brief summary.

Most countries use a territorial tax system to raise revenue from both general corporate taxes and a VAT (value added tax).  The current U.S. corporate tax system taxes a company’s worldwide income (though companies only pay tax on foreign income when the cash is re-patriated) and while some States have a sales tax, the U.S. does not have a VAT.  In order to minimize a company’s tax burden, it has become the tax accountant’s job to reduce reported income as much as legally possible using a number of standard tricks, such as shifting a company’s legal headquarters off-shore, and adding as much tax deductible debt to the corporate structure as a company can carry.

The GOP’s (Grand Old Party – refers to the Republican Party) current proposal, which is known as “destination-based cash flow tax with border adjustment” would move the U.S. to a destination, or territorial, tax system with only sales and revenue occurring in America being taxed by the IRS.  As is presently allowed, companies would be able to deduct expenses used to pay employees and buy supplies, but interest expenses would not be deductible, thus eliminating the incentive to over leverage and increase the risk of bankruptcy in down markets.  As an offset, however, capital investment could be deducted in the year it is incurred rather than depreciated over a number of years, thus incenting increased business investment.  Seem straightforward enough? Use changes in the tax code to incent companies to use more equity financing, opposed to debt, and increase capital spending.  Well, wait until you hear about the border adjustment part.

Any revenue earned from selling goods abroad would not be taxed, only imports.  This will streamline tax reporting and make it easier to prepare, but it will also create winners and losers.  Consider an example where a company manufactures a product domestically for export.  Regardless of the cost of production or sales price, the company pays no tax, at least no U.S. tax.

Alternatively, a company importing a product for domestic consumption would pay tax on the final sales price, but will not be able to deduct the cost of the imported good.  If there are no domestic manufacturers, which is the case for many apparel and foot wear products, prices would either increase by the amount of the import tax, or the importing company’s profit margins would contract, or some combination of the two.

There is a third alternative, however, namely the U.S. dollar could appreciate, which would effectively neutralize the negative cost of the import tax by lowing its price in dollar terms.  In order to compensate for a 20% border adjustment, analyst forecast the U.S. dollar could increase up to 25%, at least in theory.  If there are domestic manufacturers competing with the importers, the importers will be at a big disadvantage as the domestic manufacturers will be able to deduct the cost to produce the product, but the importer will not.  This would provide a big incentive to manufacture goods in the U.S. if they are going to be consumed in the U.S., which is likely the whole point of border adjustments.

Depending on an importer’s margins, some sectors could see their after tax profits decline under this proposal, even if the corporate tax rate falls from 35% presently to the 20% proposed by the GOP.  This might seem a bit harsh, but it would help level the playing field given U.S. exports to countries such as Mexico are assessed a VAT when entering the country.  Also, the tax revenue generated from taxing imports, which is estimated could total about $1.2 trillion over 10 years, would go a long way to funding the decrease in the tax rate to 20%.

There are still many questions and details that need clarification, such as what the transition period would look like, and whether commodities would be included in the list of imports being adjusted.  This would be a big issue for the Canadian energy and lumber sectors.  If it becomes law, however, the implications for the global economy would be significant.

Will the Republican’s be able to implement something as transformational as this?  You can bet the lobbyists will be all over this, and the battle will be intense.  If this were the only item on Trump’s agenda, we would guess it could take the best part of 2017 to pass any legislation.  But it’s not the only thing on the agenda.  In fact, it’s likely not even top of the list.  That spot is reserved for health care reform, namely repealing and replacing Obamacare (aka The Affordable Care Act).  And if you think corporate tax reform is going to be tough to get consensus on, wait until the debate on healthcare heats up.  Let’s just say healthcare reform is the policy widow maker when it comes to political careers.

Just ask the Democrats, who can point more than a few fingers at rising Obamacare premiums to explain why they lost the election.  Now Democrats can just sit back and watch the Republicans try and fix the unfixable.  Here’s the problem, over 20 million people that didn’t previously have access to health care insurance were able to gain coverage thanks the ACA.  If Obamacare is repealed, what happens to those 20 million potential votes…..I mean lives?  Republicans want to eliminate the provision that requires all individuals pay for some level of heath care insurance (or pay a fine), but they also want to keep the requirement that insurance companies cover pre-existing conditions.  Good luck getting an insurance company to tackle that money losing proposition.

Given the cost of the premiums, a lot of healthy people wouldn’t sign up until they had a medical problem, which means insurance companies would have to charge even higher premiums or be prepared to lose a lot of money insuring a pool of mainly sick people.  Now, it appears most American’s are not even sure they want Obamacare to be scrapped.  A Kaiser Family Foundation poll recently found only 25% of Americans support scrapping Obamacare before a replacement is finalized, and there appears to be no consensus on what a better alternative would looks like.

During the presidential campaign, the Donald promised to repeal Obamacare, and to do so immediately, but he was vague on the details of what he was going to replace it with, saying only it would be terrific. He wants to make good on his promise, but coming up with a new program will take up valuable political capital, funds that then won’t be available for corporate tax reform.

This doesn’t rule out corporate tax reform, but it does make it tougher, especially given the sweeping changes proposed and the inevitable fall out.  For example, what happens if the dollar actually does appreciate 25%?  Already a strong dollar is starting to impact corporate profits and the U.S. economy.  Macroeconomic advisors estimate a further 10% appreciation in the dollar over the next three years could result in a nearly 2% hit to GDP growth and inflation would trimmed by over 1%.

Where does this leave the Federal Reserve?  Tax reform would stimulate the economy, which would mean monetary policy could be normalized more quickly.  But how can the Fed predict how successful the Republicans will be in implementing tax reform and what impact it might have on the economy?  As was widely expected, the Fed raised the Federal Funds Rate in December by 25 basis points, their only increase in 2016, and only the second time they have tightened in the last 10 years.

The central bank has telegraphed three increases in 2017, and three more in 2018.  We know, this is what they said last year, and they ended up only raising once. The difference this time is The Street is more in line with Fed’s thinking, and if Trump is successful in implementing his aggressive fiscal policy platform, it could even be conservative.  On the other hand, if the dollar appreciates 25%, it would be hard to see how the Fed could aggressively raise rates as well.  I mean, how high do you want to push the dollar anyway?

Even though the Fed wants to raise rates, and they know Trump wants them to (or so he said during the campaign), we suspect Janet and the gang will be extra cautious given the uncertainty over what might happen.  As such, risk of higher inflation could be an issue in 2017.

The implications of a strong dollar extend far beyond the U.S. economy.  Emerging market companies have been big borrowers of U.S. dollar denominated debt, which becomes more expensive to service when the dollar appreciates.

China is probably the market’s biggest concern, with credit growth in general soaring to levels mirroring other countries suffering credit bust after a sharp run up in credit growth. A strong dollar only makes the situation worse, with Chinese corporations on the hook for an estimated $1.2 trillion in foreign currency loans as of the third quarter, most likely denominated in U.S. dollars.

In order to prevent the Yuan from falling too quickly, the People’s Bank of China has been buying Yuan, which has helped push China’s foreign currency reserve down to its lowest level since February 2011 at just over $3 trillion.  It is estimated the central bank has burned through about $1 trillion in reserves protecting the Yuan over the last 17 months, a pace it cannot keep up.  Some analysts estimate China needs to maintain a minimum $2.6 to $2.8 trillion in reserves, while others believe China could afford to see the total fall as low as $2 trillion.

In order to help stem the outflows, China recently imposed tighter controls over foreign exchange transactions and rejigged the basket of currencies it uses to peg its currency.  China has added more currencies to the basket and reduced the weight of the U.S. dollar so to allow the Yuan more slack against the surging greenback and reducing the need to burn through more reserves, protecting the Yuan.

China would like to keep the Yuan above the seven Yuan to the U.S. dollar mark.  They would also like to maintain $3 trillion in FX reserves.  They likely won’t be able to do both, not unless capital controls are tightened even more or domestic interest rates jacked up even higher.  And on top of this, President Trump wants to apply tariffs to Chinese imports?  It could be an interesting year for China, and capital markets.

Trump appears to have his sights set on squeezing China, claiming they are currency manipulators even though the opposite was likely the case last year.  At the same, time he appears to be extending an olive branch to Russian strongman Vladimir Putin.  Trump’s cabinet is full of businessmen short of government experience, and his chosen method of communicating his views continues to be Twitter.  At best, he is unconventional, in a good way.

Washington is full of lobbyists with special interests.  The swamp needs to be drained and only an outsider like Trump can do it.  Trump just might “Make America Great Again.”  At worst, well, we’ll just leave this to your imagination, but a trade war with China would be a good place to start.

From a market’s perspective, we would be a little cautious.  We actually like the direction the economy is taking and thus would still be inclined to favor equities over bonds.  Even when bond prices continued to rally and interest rates dove down to unprecedented levels last year, we believed economic growth would be slow, but steady, and earnings growth would lead the market higher.

Now, however, equities have rallied and interest rates have rebounded because of what Trump might do, which while possible, will likely take longer than the market is presently discounting.  For this reason, we would be cautious in adding risk to investment portfolios presently and would look to continue holding a diversified asset mix in order to protect against potential corrections in the short term.

Current volatility is well below five-year averages as investors appear to be ignoring the potential geopolitical risks surrounding the new administration, even while most strategists believe the S&P 500 will end the year at 2300, near where it is trading now.  Higher volatility would appear to be a good bet and markets will need to adapt to a market environment that is likely to be fluid.  Be prepared to change course as needed.

What did you think of December’s economic activity?  Let us know in the comments below!

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