By Rob Edel, CFA & Jeff Ryan, CIM, BA
Highlights This Month
- Consistency was key in 2017.
- U.S. Tax Reform was passed mid-month. What this means for economic growth.
- Watch inflation as an indicator of what’s in store in 2018.
- The Federal Reserve: where are interest rates going this year?
- It’s time we have the talk about marijuana.
- What to keep an eye on in 2018.
Read the monthly commentary in PDF format.
The Nicola Wealth Management Portfolio
Returns for the NWM Core Portfolio Fund were down 0.1% in the month of December but rose 8.0% for 2017 in total. The NWM Core Portfolio 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.
As mentioned earlier, the Canadian and U.S. yield shifted higher and flattened in 2017. This trend was in full force last month as well, with Canadian two-year yields increasing 0.26% versus a 0.16% increase in 10-year yields. Two-year yields in the U.S. increased 0.10% while 10-year yields were unchanged. For the month, the NWM Bond Fund was up 0.1% and gained 3.3% in 2017; a good result in a tough interest rate environment.
NWM High Yield Bond Fund returned -0.8% compared to +0.3% for the Bank of America Merrill Lynch U.S. High Yield Index. Our component funds were all fairly flat and the NWM High Yield Bond Fund was down due to the 33% exposure to a weaker U.S. dollar. For the year, the NWM High Yield Bond Fund returned +3.4% compared to the +7.5% for its benchmark, dragged down by its conservative positioning and weaker U.S. dollar. This fund is positioned for higher yields plus some upside returns should there be credit market volatility in 2018.
The stronger Canadian dollar also negatively impacted the NWM Global Bond Fund, which was down 2.2% in December and only managed a 1.7% return in 2017.
The NWM mortgage pools continued to deliver consistent returns with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund both returning +0.4%, same as last month. For the year, the NWM Primary Mortgage Fund returned 4.1% and the NWM Balanced Mortgage Fund was +5.2%. 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 are in no way a predictor of future performance), are 4.4% for the NWM Primary Mortgage Fund and 5.2% for the NWM Balanced Mortgage Fund. The NWM Primary Mortgage Fund ended the month with a cash of $3.9 million, or 2.4%. The Balanced Mortgage Fund ended the month with $85.4 million in cash or 17.4%.
The NWM Preferred Share Fund returned 0.3% for the month while the BMO Laddered Preferred Share Index ETF gained +0.4%. For the year, the NWM Preferred Share Fund increased 15.7% while the BMO Laddered Preferred Share Index ETF was up +14.6%. Continuing the trend we saw at the end of November, the first week of December saw a sharp sell-off before a subsequent recovery. The sell-off impacted almost all names as low liquidity and four new issues the week prior hurt the market. Liquidity continues to be a major contributor to the overall volatility of preferred shares. ETF’s have grown to over $7-billion in assets, holding nearly 10% of the entire preferred share market. Additionally, several banks have structured complex notes which derive their value from preferred shares. Once these investments start to unwind they may further impact preferred share liquidity.
Canadian equities were stronger in December, with the S&P/TSX +1.2% (total return, including dividends) and finished the year up 9.1%. The NWM Canadian Equity Income Fund returned +1.4% in December and +11.1% in 2017. The NWM Canadian Tactical High Income Fund was +1.5% in December and also gained 11.1% for 2017. Strong consumer discretionary and lumber sector performance, along with prudent stock selection in the energy sector helped returns during the year. No new positions were added to the NWM Canadian Equity Income Fund in December. In the NWM Canadian Tactical High Income Fund, Guardian Capital and Uni-Select helped returns last month, while Winpak and Cineplex detracted from performance. This fund still maintains a low net equity exposure (current delta adjusted exposure is 38%), which helps the fund’s relative return in a down market, but hurts relative returns when the S&P/TSX is strong.
Foreign equities were weaker last month with the NWM Global Equity Fund -1.1% compared to a 1.6% decline in the MSCI All World Index and a 1.8% drop in the S&P 500 (all in Canadian dollar terms). Results for our external managers were also lower last month with Lazard Global -0.4%, Pier 21 WorldWide Equity Strategy -1.2%, BMO Asia Growth & Income -1.3%, Pier 21 Value Invest -1.3%, and Edgepoint Global Portfolio -1.4%, and our new internal Europe Australasia & Far East (EAFE) quantitative investments returned -0.9% (the iShares MSCI EAFE ETF was -1.6%). For 2017, the NWM Global Equity Fund gained 16.0% compared to a 14.7% increase in the MSCI All World Index and a 13.5% gain in the S&P 500 (all in Canadian dollar terms). Results for our external managers in 2017 were as follows: Lazard Global +15.2%, Pier 21 WorldWide Equity Strategy +23.9%, BMO Asia Growth & Income +14.4%, Pier 21 Value Invest +10.7%, and Edgepoint Global Portfolio +19.2%.
The NWM U.S. Equity Income Fund increased 1.4% in U.S. dollar terms in December and was +24.6% for 2017. The NWM U.S Tactical High Income Fund increased 0.6% in December and +12.6% in 2017 versus a 1.1% increase in the S&P 500 in December and a 21.8% increase for 2017 (all in U.S. dollar terms). In the NWM U.S. Equity Income Fund, relative performance was helped by strong performance in energy, materials, industrials, and financials. In December, we sold our position in Verizon and used the proceeds to add to our other existing positions in the telecom sector. As for the NWM U.S. Tactical High Income Fund, we were “called away” on Costco, Lazard, L Brands, Starbucks, Synchrony, and Tractor Supply Company, while assigned an allocation in AIG from our naked put position. We wrote one new naked put position during the month, M&T Bank. The net equity exposure (delta) in the NWM U.S. Tactical High Income Fund is down to a very defensive 15%.
In real estate, NWM Real Estate Fund was down 0.2% in December versus the iShares REIT Index +1.3%. For 2017, the NWM Real Estate Fund was +4.4% versus the iShares REIT Index +9.3%. We report our internal hard asset real estate limited partnerships in this report with a one-month lag. As of November 30, 2017, performance for SPIRE Real Estate LP was +1.5%, SPIRE U.S. LP +0.7% (in USD), and SPIRE Value Add LP +1.4%. Year-to-date returns for SPIRE Real Estate LP were +10.1%, SPIRE U.S. LP +8.2% (in USD), and SPIRE Value Add LP +18.8%.
The NWM Alternative Strategies Fund was up -0.6% in December and +2.9% for 2017 (these are estimates and can’t be confirmed until later in the month) with Winton -0.9% in December and -3.2% in 2017, Citadel -1.3 and +4.3% (this position is being redeemed at the request of the manager at the end of the year), and Millenium -2.1% and -0.6%. Of our other alternative managers, all showed positive performance with RP Debt Opportunities +0.3% and +7.4% in 2017, Polar North Pole Multi-Strategy +1.0% and +7.0%, and RBC Multi-Strategy Trust +0.2% and +7.9%. Winton, Citadel, and Millenium are based in U.S. dollars so were negatively impacted by the strong Canadian dollar last year. Precious metals stocks were stronger last month with the NWM Precious Metals Fund +2.2% while gold bullion declined 0.4% in Canadian dollar terms. For 2017, the NWM Precious Metals Fund was up 3.1% versus gold bullion +6.2%.
December In Review
With 2017 on the books, we look back past December and recap what worked and didn’t work throughout the year, as well as look forward to what might unfold in 2018. In addition, given what we wrote last month on Bitcoin, we thought we might add our thoughts on another hot investment fad, marijuana stocks.
The markets in December continued to trend higher, as they did all year, with the S&P/TSX up 1.2% and the S&P 500 +1.1% (in USD terms). For 2017, the S&P/TSX gained 9.1% while the S&P 500 rose a remarkable 21.8%. When translated into Canadian dollar terms, U.S. stock returns were more modest, with the S&P 500 +13.5% for the year and actually down 1.8% in December due to the strong appreciation in the Canadian dollar last year, which was up 2.5% in December and +6.5% for the year.
Local currency returns were, in fact, strong globally, with soaring stock prices adding more than $9 trillion to equity values last year. China was one of the few exceptions, with the Shanghai Stock Exchange, which is mainly comprised of large state-owned companies, up 8.7% (in local currency) in 2017, while the smaller more growth-oriented Shenzen Stock Exchange was actually down 2.7%. Both were down slightly last month. On the other hand, Europe, Japan, and emerging market stocks all outperformed Canadian and U.S. exchanges last year.
Perhaps even more notable than the absolute returns stocks achieved last year was the consistency in which the gains were earned. The S&P 500 did not experience a single month in the red last year and, according to market historian James Stack, there wasn’t a single trading day where prices fluctuated more than 2%. On only four occasions last year did the market fall at least 1% during a single trading session and, as of early January, the market had gone over 380 days without experiencing a 5% drawdown which, according to Goldman Sachs, is within weeks of setting the all-time record dating back to 1929. Not only is the current bull market the second longest on record, it’s also probably the most boring, but in a good way.
The bond market also stayed on script in December with both the Canadian and U.S. yield curves continuing to flatten, a trend we saw throughout 2017 as short interest rates pushed higher while longer rates lagged behind. U.S. 10-year yields actually ended the year virtually unchanged at 2.41% after ending 2016 at 2.44%. It was on the shorter end of the curve where most of the action took place, with yields in both Canada and the U.S. moving higher.
Like with 10-year yields, 2-year yields in Canada moved up more than in the U.S. and, in fact, rose above U.S. rates for a period of time in September and October. While Canadian yields are again below U.S. yields, the narrowing gap between Canadian and U.S. 2-year yields in the second half of the year was a large contributor to the strength in the Canadian dollar last year. Rising rates also put pressure on bond returns and yield-oriented investments in general.
Rising interest rates would typically be associated with stronger economic growth, which is mainly what we saw last year, not only in the U.S. but globally. Perhaps the biggest surprise for economists in 2017 was just how well the global economy did compared to the U.S. growth. The results can be seen not in just equity returns, but also in global bond yields which, like in Canada and the U.S., started to slowly move higher in 2017.
U.S. economic growth could get an added boost in 2018 given U.S. tax reform legislation was finally passed in mid-December. As highlighted last month, Senate and House Republicans were able to reconcile their differences and agree on a tax reform bill that was quickly signed into law by a president hungry for a legislative win in his first year in office. The corporate tax rate falls from 35% to 21% and U.S. companies will be assessed a one-time tax of 15.5% on liquid, accumulated foreign profits (8% tax on illiquid assets).
Going forward, a territorial tax system will be used such that corporations will generally avoid paying U.S. tax on their foreign profits. The new 21% tax rate and generous rules, regarding the deduction of capital investment and depreciation, are meant to incent companies to produce more goods in the U.S versus moving their operation overseas.
Estimates on the impact of the tax cuts vary. Some estimate they could help boost GDP growth by 0.25% to 0.50% over the next two years. President Trump’s estimates are much higher. If Trump is wrong, the fallout will likely result in a higher U.S. debt/GDP ratio. As for specific companies and industries, most will benefit and corporate earnings estimates will get a boost in early 2018. This should be positive for the market and, while some of this is already discounted into the market, we would expect further upside in early 2018.
Given stronger economic growth, stagnant U.S. 10-year yields during 2017 were somewhat of a conundrum for investors. If the economy was recovering, why were interest rates not rising? Short-term rates were increasing due to expectations of tighter monetary policy, but longer-term rates were not. The outcome, flattening of the yield curve, has resulted in some investor angst as it could indicate the economy might be in the later innings of its growth cycle and a recession might be around the corner. This is typically only the case, however, if the yield curve continues to flatten and eventually inverts. Even then, it can take many months for the process to unfold.
While it is true the current economic expansion at over eight years and counting is the third longest in U.S. history, it has also been one of the slowest. With prospects for productivity growth low and demographics unfavorable, many doubt economic growth will accelerate anytime soon and the slow growth recovery and low 10-year bond yields could be with us for the foreseeable future.
Perhaps nothing is more indicative of the slow growth economy as inflation. One of the reasons cited for the lack of traction in 10-year bonds yields has been the inability of inflation to move higher. There are many theories on why, despite an unemployment rate of 4.1% that is considered below full employment, inflation has failed to accelerate. Until it does, investors will remain skeptical of the sustainability of the economic recovery. With the U.S. and global economies finally closing the economic output gap created during the great recession, many feel inflation should finally start to gain some traction, especially given recent economic strength.
Inflation will be a key indicator to watch in 2018. Not only will it impact longer-term interest rates, but it will also influence what happens in the short end of the curve as well. The U.S. Federal Reserve has indicated they expect to raise short-term interest rates three times, or 0.75% (three 0.25% increases), in 2018 and twice more the following year. This will be hard to do if inflation remains elusive. Alternatively, if inflation heats up, three increases might not be enough.
Regardless, despite three rates hikes last year, the Chicago Fed’s National Financial Conditions Index indicates monetary conditions are at their loosest point since January 1994. A weaker dollar, lower long-term interest rates, and a more favorable borrowing environment have given the Federal Reserve ample room to keep increasing short-term rates. JP Morgan estimates it would take a “real” Fed Funds Rate of 1% before higher rates start to impact the market.
Given an upper range on the current Fed Funds Rate of 1.5% and inflation of around 2%, the real Fed Funds Rate of -0.5% would leave the Central Bank room to increase rates 1.5%, or six more times. We believe inflation will firm in 2018 and the Federal Reserve will continue to move rates higher, but not by more than the three hikes already forecast. A gradual and measured tightening by the Fed in a slowly recovering economic environment is ideal for investment returns.
With interest rates starting from such a low base, one could argue that lower rather than higher yields would be a greater threat to valuations given lower interest rates are associated with lower economic growth. According to forecasters, however, a recession is not likely in the near term with recent polls assigning a 14% probability of a recession in the next twelve months, ramping up to 29% in two years and 43% in the next three years.
Higher rates could become more problematic, however, if they are accompanied by a decline in liquidity. While The Federal Reserve ended their quantitative easing program in October 2014, the European Central Bank (ECB) and the Bank of Japan have been voracious purchasers of their own government bonds (and other fixed income securities).
With the global economy no longer in crisis mode, the need for extraordinary monetary measures like quantitative easing becomes harder to justify. The ECB has already announced plans to start tapering their future bond-buying plans and many expect the Bank of Japan to eventually follow suit. By early 2019, Bank of America Merrill Lynch estimate global central bank balance sheets should start contracting, thus reducing global liquidity. In theory, this shouldn’t be a problem for a healthy global market, but the correlation between higher central bank balance sheets and higher stock prices cause one to pause.
Higher inflation is not the only thing central banks risk by not tightening monetary policy, asset bubbles are also a concern. So far, we don’t see this as a widespread issue. While stock valuations are high and the duration of the current bull market is long by historical standards, market sentiment remains balanced. Newsletter writers are bullish, but sell-side indicators are still neutral and the index performance of the S&P 500 does not have the same upward trajectory as past bubbles. The rise has been calm and orderly.
That doesn’t mean we don’t see any asset bubbles. Market action in select technology companies like the FANG stocks (Facebook, Apple, Amazon, Netflix, and Google) are more concerning, as is the dramatic rally in Bitcoin and other cryptocurrencies. Given we wrote about Bitcoin last month, we thought we would say a few words about marijuana stocks, another area we’ve received numerous questions on, and in particular the burgeoning industry in Canada.
The Marijuana Talk
In Canada, access to cannabis for medical purposes dates back to 1999 but regulations have undergone various changes in recent years with one of the most substantial being the implementation of the Marijuana for Medical Purposes Regulations (MMPR) by the Government of Canada in June 2013. This helped create the commercial industry that exists today.
Working towards fulfilling a campaign promise, Justin Trudeau’s Liberal government has been pushing to legalize, regulate, and restrict access to marijuana with July 1st, 2018 set as the current target for national recreational legalization. The legal age for purchase has been recommended at 18 and older by the Canadian government-appointed task force; however, the individual provinces and territories will be given the ability to set their own restrictions similar to the varying rules regarding the legal drinking age across Canada. Distribution rules, pricing regulations, and taxation are still being formalized.
Under the current system, licensed producers within the medical program are able to ship to patients through the mail. For recreational use, each province is looking at their own potential solutions including sales through provincial liquor stores, pharmacies, or dedicated stores. The future for the vast number of marijuana dispensaries that have popped up in recent years that have been operating illegally is still uncertain with some expecting widespread enforcement and shutdowns once formal legislation is passed. Others believe some of these storefronts may be legitimized as a network of distribution for the licensed producers; building out their own storefront distribution would be costly.
Full legalization by July 2018 is not a sure thing, and some provinces and municipalities have been vocal that they feel the current plans are rushed and leave too much of the burden on them. While some uncertainty remains around the exact timing of recreational legalization in Canada, negative news headlines have caused volatility.
The investor interest in the publically traded marijuana companies has been relatively undeterred with some viewing this as an early opportunity to get into a new growth industry before it becomes more widely established. We’ve witnessed this sentiment with the meteoric rise in stock prices for many of these publically traded marijuana companies in recent years. Though the potential market opportunity could be huge, we have concerns about the many unknowns.
Given some of the stigma around recreational use, research studies into the efficacy of medical marijuana as a treatment have been limited in comparison to those done for pharmaceutical drugs and because of this there is ambiguity around how big the overall medical demand could be. Typical estimates of the total addressable market in Canada have varied from between $6-10-billion annually and upwards of $23-billion by Deloitte in an October 2016 report. The size and potential value of the recreational market is one of the biggest sources of speculation for investors as many believe the demand from potential recreational users far exceeds that of medical users and with it the current supply available.
Without adequate barriers to entry, the market could become oversaturated with producers. Aside from uncertainties around regulation, pricing, and supply, questions also remain on how producers will be able to differentiate their products if there are restrictions on advertising imposed by the government similar to those in the tobacco industry. The valuations for many marijuana companies have been bid up regardless of their actual production, sales or profitability by investors trying to find the next ‘marijuana unicorn,’ a distinction first used to represent a company with a $1-billion+ market cap.
Consolidation in the industry seems like a logical next step given the number of producers out there and the distribution advantages that come with scale, which should benefit some of the larger companies. Given the perceived supply shortfall that may occur if estimates of the recreational market are off their mark, the industry has witnessed vast land acquisitions, as well as acquisitions to meet expected future production requirements. There is limited assurance that those with the largest market cap today, or those that were early pioneers in the space, will be around a few years from now given the majority of these companies are not currently profitable. This is a lesson that should be taken from the irrational exuberance that emerged during the dot-com bubble.
In our view, the current industry enthusiasm has led to a detachment of stock prices from fundamentals and speculative valuations given the current profitability of many of these companies. The volatility and lack of consistent cash flows currently attributable to most of these companies don’t fit our normal criteria for selecting investments. While we acknowledge that there could be legitimate opportunities for investment, until there is more formal guidance on regulation, pricing, and supply, for us, the industry is uninvestable. In a market correction driven by higher interest rates and lower liquidity, speculative sectors like marijuana would likely suffer more. Buyer beware.
Looking Ahead
With stronger global economic growth, stimulative monetary and, now, fiscal policy, investment returns should again provide solid returns in 2018. We expect more volatility than last year and a pullback in the near-term could be expected and even welcomed, given recent strength in the markets. However, we don’t see the necessary conditions for a more meaningful correction. What would change our minds? If inflation comes in higher than expected and central banks tighten more aggressively. Also, there is a myriad of geopolitical risks that are probably not being properly discounted by the market.
At the top of our list would be increased protectionism and trade wars. The U.S. backing out of NAFTA is a legitimate risk for the Canadian economy (as well as the U.S. economy) and the Canadian dollar; this is just the warm-up for the big show between the U.S. and China. North Korea is still an issue that needs to be resolved but could become overshadowed by events in the Middle East given the increased tensions between Saudi Arabia and Iran. Iran itself is a country to watch given recent demonstration against the ruling Islamic government. Of course, political uncertainty in Europe is always an issue and even though mainstream parties appeared to gain ground against populist opponents last year, Angela Merkel still hasn’t been able to form a minority government and Italian elections in March are likely to see the see the populist Five Star Movement gain the most votes.
Coming up later in the year are U.S. mid-term elections, which could see a Democratic wave unseat the Republican’s hold on Congress. While this appeared a remote possibility after the 2016 general election, just a year of living through President Trump has put both the Senate and House back in play. Perhaps an even greater risk for stability resides in the White House itself. The Mueller investigation and the threat of impeachment may occupy the headlines, but the real concern would be if key White House staff members, namely the so-called adults in the room, were to leave in frustration. Yes, 2018 is likely to be anything but dull.
What did you think of 2017’s markets? Start a discussion 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. Returns are quoted net of fund/LP 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. Please speak to your NWM advisor for advice based on your unique circumstances. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.
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