Investors Navigate Through a Fog of Uncertainty


By Rob Edel, CFA

Highlights This Month

Read this month’s commentary in PDF format.

 

The NWM Portfolio

Returns for the NWM Core Portfolio Fund increased 0.3% for the month of January.  This 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 yields were virtually unchanged last month.  The yields curve continued to steepen, but the impact was very mild, with 10-year yields backing up 4 basis points to 1.76% while 2-year yields moved up 3 basis points to 0.77% in December.  U.S. yields were even less exciting, with 10-year yields increasing 1 basis point to 2.45% versus a similar increase in 2-year yields which ended the month at 1.20%.  The NWM Bond Fund was +0.2%..

High yield bonds were down marginally in January, due largely to the negative impact of the strong Canadian dollar.  The loonie’s 3.1% appreciation during the month detracted from the return of our unhedged U.S. high yield issues and resulted in the NWM High Yield Bond Fund returning -0.1%.

The strong Canadian dollar was also a factor for the NWM Global Bond Fund, which declined 1.1% in January.  The weak Mexican peso and decline in several Asian currencies also hurt performance last month.

The 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 January.  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 the NWM Primary Mortgage Fund and 5.3% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund ended the month with $21.3 million in cash, or 12.9%.  The NWM Balanced Mortgage Fund ended the month with $72.2 million in cash, or 15.2%.

The NWM Preferred Share Fund was up 5.1% for the month of January while the BMO Laddered Preferred Share Index ETF returned 4.6% as market returns were strong across the board amongst all types of issues. In the NWM Preferred Share Fund, we decreased our weight in preferred shares that were trading above par with wide resets in anticipation of some weakness in the coming months with new issues; we also increased our weight in preferred shares with smaller resets that have more upside to rising interest rates.

Although 5-year Government of Canada bonds remained flat for the month, we invested in preferred shares that have upside potential based on the 5-year forward market. Demand pressures continue to outstrip supply in the marketplace. A combination of retail investors switching individual holdings for funds, along with more traditional bond investors starting to invest in the space, have continued the trend of institutionalizing the preferred share marketplace.

Strong performance in the basic material sector drove Canadian equities higher with S&P/TSX up 0.8% (total return, including dividends) in January.  The NWM Canadian Equity Income Fund was down 0.2%, mainly due to having no exposure to the gold sub-sector.  The NWM Canadian Tactical High Income Fund gained 1.1%, which was a good result given the low current delta (equity exposure) in the fund .  The NWM Canadian Tactical High Income Fund also has no allocation to gold.   In the NWM Canadian Equity Income Fund, we initiated a new position in Intertape Polymer.  In the NWM Canadian Tactical High Income Fund, we added new naked put positions in Onex and Hudson’s Bay, and added to our existing position in KP Tissue.

Foreign equities were mixed stronger in January with the NWM Global Equity Fund up 0.1% compared to a 0.7% decline in the MSCI All World Index and a 1.2% fall in the S&P 500 (all in Canadian dollar terms).  Of our external managers, Pier 21 Carnegie and Edgepoint were both up 1.4% and BMO Asia Growth & Income was not far behind at +1.2%, while Pier 21 Value Invest and Lazard Global both declined, falling 0.8% and 1.8% respectively.

The NWM U.S. Equity Income Fund increased 2.3% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.5% versus a 1.9% increase in the S&P 500 (all in U.S. dollar terms).  In the NWM U.S. Equity Income Fund, we added to our existing positions in Walmart, Verizon and Waste Management, while trimming our positions in the banks.  As for the NWM U.S. Tactical High Income Fund, we established a new short put position in Starbucks.

Real estate was weaker in January with the NWM Real Estate Fund down .5% versus the iShare REIT index -0.1%.

The NWM Alternative Strategies Fund was down 1.3% in January (these are estimates and can’t be confirmed until later in the month).  The strong Canadian dollar was a headwind for all our Altegris feeder funds, with Citadel -1.4%, Millenium -1.9%, Brevan Howard -2.9%, and Winton -4.2%, for our other alternative managers, only MAM Global Absolute Return Private Pool was in negative territory, down 1.4%.  RP Debt Opportunities was +1.4%, RBC Multi-Strategy Trust +1.3%, and Polar North Pole Multi-Strategy +0.6%.

Precious metals started the year on a strong note, with the NWM Precious Metals Fund +7.1% and gold bullion up 2.3%.

January In Review

It’s a new year with a new U.S. president, but that’s about all we can be sure of right now.  From both an economic and geopolitical perspective, the world appears very uncertain to us.  To the surprise of most investors, interest rates and the U.S. dollar moved materially higher after the November 8th election of Donald Trump.

In January, however, the rally in bond yields stalled and the dollar declined.  Against the Canadian dollar the greenback depreciated over 3%.  Only stocks maintain their upward momentum last month, with the S&P/TSX gaining 0.8% and the S&P 500 up 1.9%.

The Dow Jones Industrial Average, in fact, hit a milestone all time high late in the month, closing above the 20,000 mark.  We’re not ones for reading too much into big round number milestones, especially for an antiquated index like the Dow.  Created in the days of the slide rule, if mistakes in the 120 year old index were corrected, Birinyi Associates calculates the Dow would have actually passed the 30,000 mark late last year.

The index is also price weighted versus market weighted, which means a stock like Goldman Sachs, which recently traded at $236 per share, has about twice the impact on the index as Apple, which trades hands for about $132 per share but has six-times the market cap of Goldman.   Regardless, the index tracks the broader market remarkably well, and while the Dow’s 0.6% gain trailed the S&P 500 by over 1% last month, the Dow is up over 7% since the election versus the nearly 6% advance in the S&P 500.  Milestone or not, equity investors are over the moon!

Dow Jones photo collage

Not only are stocks hitting all-time highs, but market volatility is at its lowest level since 2014 and close to its lowest reading in the history of the VIX.  Investors appear to be very complacent, and yet we suspect the average person reading their daily newspaper or watching the evening news would be anything but.

Case in point, the Global Economic Policy Uncertainty Index, which tracks the relative frequency of stories relating to economic policy uncertainty from major newspapers in 18 countries, recently hit a 20 year high.

Either investors are ignoring the uncertainty being reported in the news because they are not as concerned with the issues as journalists, or they don’t know how to assess the issues and have therefore chosen to ignore them.  We think both are probably true.  The media got the election of Donald Trump wrong by not correctly understanding what matters to Americans; this is likely still the case with trust in the media continuing to fall.

As an investor, however, it’s hard to make investment decisions on policies that may take months to take shape, or might be scrapped entirely.  The divergence between market volatility and economic policy uncertainty is unnerving; however, stock market returns have historically been poor after periods of low volatility.

Collage of volitility graphs and Trust in Mass Media chart

Like stocks in general, we suspect market volatility is overdue for a “Trump Bump” of its own.

The Donald has only been in office a few weeks, and the world is already exhausted.  On day one, Trump permanently withdrew from the Trans Pacific Trade Partnership and followed up over the ensuing days by having “a tough call” with the Australian Prime Minster and accusing Germany and Japan of manipulating their currencies; and these are some of America’s strongest allies!

Following up on campaign promises, Trump has been busily signing executive orders (which bypass congressional approval), including a 90-day ban on travel to the U.S. by citizens of Iraq, Syria, Sudan, Libya, Somalia, and Yemen.  The fact these select countries are primarily Muslim was not lost on Trump’s critics and the rest of the world.  To some observers, President Trump’s actions appear contrary to American foreign policy norms and are intended to end or radically change the international institutions and alliances established over the past 70 years.

Trump has an “America first” mentality, which the rest of the world reads as meaning “everyone else is second.”  As a result, the spike in economic policy uncertainty mentioned above is not just an American phenomenon.  In fact, while uncertainty is elevated in the U.S., it’s nowhere near the all-time high reached in 2011 during the debt ceiling crisis.  It’s the rest of the world that is setting records, and while Trump isn’t entirely responsible, he is a major contributor.

Case in point, the Science and Security Board of Atomic Scientists recently moved the hands of the doomsday clock from three minutes to two and a half minutes to midnight, the closest it’s been to signaling an impending global disaster since 1953.

Not everyone disagrees with the “America first” direction Trump is taking, however, it plays pretty well with a lot of the same supporters who voted for him. and many of his executive orders, including the travel ban, have greater than 50% support in America.

Daily headlines and the uncertainty around what Trump will do next are exhausting.  It’s all people are talking about because it has the potential to impact everyone around the world.  During company conference calls, despite predicting positive prospects for earnings next year, much of the discussion has centered on President Trump.  On top of the list of concerns is the new administration’s plan for trade and fears of increased protectionism.

Trump approval ratings collage

First up on Trump’s apparent trade hit list is NAFTA, and specifically Mexico.  During the campaign, Trump targeted illegal immigrants from Mexico and NAFTA, which he described as “the worst deal ever signed,” as issues he would quickly correct if he was elected President.

He talked about building a wall, but most thought it mostly symbolic and a campaign stunt.  After all, there already is almost 700 miles of fencing separating the Mexican and U.S. border, with much of the rest being either open desert, private land, or along the Rio Grande.  According to Reuters, an internal U.S. Department of Homeland Security report has pegged the total cost of a wall (which would really be a series of fences) at nearly $22 billion and a construction time of more than three years.

As for illegal immigrants, the numbers have been dropping since the 1990’s and the total number of immigrants from Mexico has been falling steadily since 2004 with a Pew Research report claiming there are actually more Mexicans leaving America and heading back to Mexico than going the other way.

Hope that the wall and most of Trump’s outrageous comments during the election campaign were stunts meant to grab headlines went out the window when Trump signed an executive order directing federal officials to immediately begin planning, designing and constructing a physical wall. Even worse, he ordered the plans right before a planned meeting with Mexican President Enrique Pena Nieto, which was later cancelled after a Twitter war erupted between the two over who was going to pay for the wall.  Pena Nieto is already unpopular in Mexico.  Trump’s actions left him no option but to bow out.  Perhaps Mexicans can use Hilary Clinton as an example of what not to do in the future.  When faced with abuse from Trump during the election, Clinton would recite advice from Michelle Obama that “when they go low, we go high.”  Well in this case, if Trump wants to go high, perhaps Mexico should go low…. and tunnel.

USA-Mexico Wall cartoon & illegal crossings chart

So why the wall?  What’s the point?  The hope is, and we say this because it’s the only rational explanation, Trump is using it as a bargaining tactic in renegotiating the NAFTA treaty.  Trump feels NAFTA favors Mexico, and the $60 billion trade deficit between the two countries helps makes his case.

Manufacturing jobs have been shipped across the border in order to take advantage of Mexico’s cheap labor and lower taxes, but it hasn’t been a one-way street entirely.  Mexico’s agricultural industry was virtually wiped out by NAFTA and average daily wages in Mexico have increased to just $16.70 per day since 2000.  Interestingly, all the talk about a wall and tearing up NAFTA  has weakened the peso and actually strengthened Mexico’s position from a trading perspective, the opposite of what Trump wants to do.  More to the point, Mexico represents just 8% of America’s total trade deficit, and while U.S. manufacturing has declined since the NAFTA agreement was signed.

It was when China joined the World Trade Organization that manufacturing employment really started to decline in the U.S..  Sure the U.S. might have some legitimate beefs with NAFTA, such as rules of origin abuses which could allow non-NAFTA countries to import goods into the U.S. through Mexico, or Mexico’s value-added tax, which puts American exporters at a disadvantage, but are these significant enough to scuttle the entire agreement?  One would think a strong Mexico would be in America’s best interests, especially if reducing illegal immigration is a goal. Is Mexico just a warm up for the real trade battle with China?  Are Trump actions and unpredictable moves meant to throw China off-balance?  Are we giving him too much credit?

Mexico-US Trades comparison

The U.S. may have had a $63 billion trade deficit in goods with Mexico last year, but the shortfall with China was nearly $350 billion.  Trump believes skillful Chinese negotiators have taken advantage of their predictable U.S. counterparts, which has resulted in the playing field being tilted against U.S. exporters.

Many experts agree.  According to the U.S. China Business Council, foreign firms have become disillusioned with doing business in China due to regulatory barriers, competition with Chinese companies, and questionable law enforcement.  The TPP (Trans Pacific Partnership) was actually intended to counter China’s power and anti-free trade practices by establishing a more Western model of rules-based trading and the creation of a new transactional code of business conduct.

While China wasn’t an original signatory, the 12-nation pact would have isolated China and enabled Trump more bargaining power given the abundant array of alternative suppliers the TPP would have provided America in the event of a trade war with China.  Cancelling the TPP actually helps China and has enabled Chinese leaders to hold themselves out as protectors of globalization and free trade, which in reality couldn’t be further from the truth.

US-China Trade Protectionism Rising chart

A trade war is a risk and tops many investor polls as the greatest threat to investment returns in 2017, as is Trump and his unpredictable antics. So why is volatility down and stock prices up?  Simply because the economy is looking better.  Consumers are feeling better, businesses are more confident, and most economists feel there is greater upside risk to their estimates on economic growth than downside risk.

Global Growth Outlook & Sentiment Charts

And yet, growth isn’t so strong that it will compel the U.S. Federal Reserve to more aggressively increase interest rates.  Employment growth was strong last month with 227,000 new jobs created, but wage inflation remained sub-par at 2.5%.  The Fed has indicated it would like to raise rates three times in 2017, or 0.75% in total, but the market is becoming less confident that this will be the case.  The central bank’s credibility is low given they had forecast four increases last year and delivered only one.

Employment rates and wage charts

Of course, inflation is also a key variable for the Federal Reserve. While headline and core CPI have moved above the Fed’s 2% target and inflation expectations surged in the second half of 2016, the absence of wage inflation and a strong dollar mean inflation is unlikely to move significantly higher in the short term, and even less likely to impact stock valuations anytime soon.  Historically, inflation above 4% is required before investors begin to take notice, and we are nowhere close to that right now.  A little inflation is actually good for the market as it indicates economic growth is strengthening.

US inflation charts

Even if the Fed takes a slower path towards raising interest rates, higher inflation and stronger economic growth should translate into higher bond yields, which is generally what we have seen since the election.  As noted earlier, however, the momentum in yields started to stall in December and was effectively unchanged in January.  Since the election, 10-year rates have moved up more than 2-year rates, which is likely because short term interest rates are influenced more by central bank policy than market sentiment and investors feel economic growth should continue to improve over the next few years.

Interestingly, 30-year yields have not kept pace, which could mean investors are not as optimistic economic growth will be strong in the longer term, and are more willing to hold longer term bonds as a hedge against disappointing growth and deflation.  If investors believe Trump is able to deliver a meaningful long term increase in growth and inflation, why would anyone want to hold a 30-year bond yielding only 3%?  The near term economic outlook may look more promising, but there is some doubt as to what will happen in the long term.

The Market's View of Trump charts

This trade off can also be seen by the market actions of hedge funds and asset management funds.  Hedge funds, which are typically more active in the short term, have been selling bonds, which drives up bond yields; while asset management funds have been buying.  Adding to the debate is the downward pressure on prices (upward pressure on yields) by the Japan and China, who have both been reducing their holdings of treasuries.

Swaring off - US treasury yields charts

Investors like the fact that economic growth is improving, which has been the case since before the election.  They view President Trump’s plan to lower taxes and reduce regulation as having the potential to increase growth even more in the near term.  Yes, there is the risk of a trade war, but other than that, even if Trump gets nothing done, we are still left with an improving economic environment.

While we believe markets may be getting a bit ahead of themselves, and investors have become a little complacent, overall risk to economic forecasts are skewed to the upside and should allow equity returns to continue moving higher in 2017.  It’s in the longer term that investors could start to get a little more concerned.  For one, the GOP’s (Republican House of Representatives) corporate tax reform proposal that could drive the U.S. dollar even higher, despite its already strong appreciation since the election.  A strong dollar is a headwind for growth.

Second, many of Trump’s policies such as lowering the tax rate and increasing infrastructure spending, will result in higher government debt levels.  This very fact alone will make it hard for Trump to get his plans approved by the fiscally conservative republicans in congress.  If he is successful, and growth doesn’t increase as he hopes, the U.S. will have very few options available to them the next time the economy falls into recession.  Risks to the short term outlook might be skewed to the upside, but the endgame is anything but clear.

What did you think of January’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.