Annus Horribilis 2018


By John Nicola, Chairman & CEO
and
Dylan Reece, Financial Advisor & Associate Portfolio Manager

Read the pdf version

More than 25 years ago, Queen Elizabeth celebrated the 40th anniversary of her accession to the throne by stating that 1992 had, for her, been annus horribilis.

She had good reasons. Two of her children were getting divorced, Diana was involved in “Squidgy-gate” (don’t ask) as part of her separation from Charles, and there was a major fire at Windsor Castle. 26 years later and one could reasonably say that things are now looking better for The Royals.

The markets, by comparison, are a different story. The last time we used the title “Annus Horribilis” was in two successive years during the Dot Com Bust of 2000-2002. We did not repeat its use in 2008 because “horribilis” seemed too mild a word to describe that crisis. However, the end 2018 seems like a good time to revive the phrase.

 

What kind of year has it been?

Let us first review the returns of some key stock and fixed income indices and commodity prices, both for the fourth quarter (Q4) and for the 12 months ending December 31st, 2018 (all returns in local currencies).

As you can see, almost all asset classes were negatively impacted in the last three months of the year, and of the above indices only bonds and REITs posted positive returns for 2018. (Note the returns are before any fees one would incur to actually invest in these asset classes.)  If an investor held U.S. dollar denominated investments, they would have experienced a currency gain of 8.48%, which would have mitigated losses or resulted in outright gains.  However, 2018 was a year where there was almost “nowhere to hide.”

Here is just a partial list of what has occurred last year:

  • Most equity markets were at or near bear territory (drops of over 20% from their peaks earlier this summer and fall). While there was a reprieve during the last week of the year, the peak to year-end drops went from a relatively modest -13.5% for the TSX and S&P 500 to a definite bear market fall of -30% for the Shanghai Index and near bear misses of -19% for the Euro Stoxx 50 and the Nasdaq.
  • Those investors in traditional (non-Nicola Wealth) 60/40 Balanced Index Portfolio consisting of 60% equities and 40% bonds (see “Nicola Wealth vs The Marketplace” chart below) were down 2.91% in 2018 and suffered a decline of 5.46% since August 31st.  Even these results are positively inflated by the impact of our falling dollar (down 8% against the U.S. dollar in 2018, which resulted in material currency gains).  A 60/40 portfolio made up of only Canadian equities and bonds, such as Morningstar Canadian Neutral Balanced, was down 5.93% for the year and 7.40% since August 31st.  Meanwhile, the Nicola Core Composite return was up 1.85% in 2018, resulting in outperformance of 4.76% over the global 60/40 Balanced Index Portfolio and 7.78% over a purely Canadian Morningstar Canadian Neutral balanced fund balanced.  (Note that individual client returns will vary based on a number of factors.)
  • The yield curve on bonds is becoming flat and, in some countries, has inverted so that some longer-term rates are below short duration bonds. Inverted yield curves are a common precursor for recessions (and we have not had one of those for more than 10 years).
  • Trump has managed to engage most of the world in some form of trade war involving tariffs. We have yet to see whether this is his form of “The Art of the Deal” or a long-term cornerstone of his overall trade strategy. This is combined with the fact that Senior White House Officials now require reusable name tags.
  • So far it looks as though Brexit will end poorly for Britain and have a negative economic impact on much of Europe. Economic indicators in Italy and Germany are also deteriorating.
  • Canada is having to sell oil at discounted prices. Lumber, aluminum, and steel are all subject to U.S. tariffs notwithstanding the new USMCA trade deal.
  • Rising mortgage rates, tighter bank lending requirements, and higher provincial taxes on housing (primarily impacting foreign buyers, but also significant increases for resident homes in B.C. over $3 million in value), is having an impact on both pricing and volume of home sales.

Surely there was some good news in 2018. In fact, there were a few rays of sunlight.

  • Unemployment at 3.7% in the U.S. is the lowest it has been since 1969 (Bureau of Labor Statistics), and in Canada our higher rate of 5.6% is the lowest we have seen since 1974 (StatsCan).
  • Interest rates have not risen as much as was expected, and in fact five and ten-year Government of Canada bond yields dropped slightly in 2018, keeping  borrowing rates reasonably steady (mind you, not great news for savers).
  • Corporate profits for the S&P 500 are at record levels (with a major assist from the Trump Tax Cuts).

 

How do we put this in context?

A year like 2018 has a tendency to bring up many questions from investors. For those who see the glass half full the primary question would be –Is this a buying opportunity? For those who are sometimes described as nattering nabobs of negativity the question is this –if the money in my mattress made a significantly better return than my portfolio, should I move more of my assets under the bed?

At the beginning of this year we wrote that equity markets were expensive and, when combined with artificially low interest rates, that it would be difficult to achieve an inflation-adjusted return of 4% net of fees over the next five years. Historically, when equity markets have been as highly valued as they were at the end of 2017, traditional 60/40 balanced portfolios have averaged a real rate of return close to zero over the five years following. We presented this information at our 2018 Strategic Market Outlook Event.

On our public website we have a similar chart to the one below.

It shows that it has not been a good time to be invested in traditional 60/40 (stock/bond) portfolios for a long time.  Since December 31st, 1999 the Morningstar Canadian Neutral Balanced Fund Index had a net return of about 4.17% annually, or about 2.17% after inflation, and a passive 60/40 index portfolio returned only 3.63%, or about 1.63% after inflation.  These results are well below the 4% real rate of return we feel clients require to build wealth and retire comfortably.

Our typical clients’ returns (represented by the blue line called “Nicola Wealth Core Composite Return (net of fees)” has returned 6.85% during this same time period, or approximately 4.85% per year after inflation.

The period since 2000 has been a challenging one for equity investors. In Canadian dollars, the TSX, S&P/500 and the MSCI World have returned 5.41%, 4.53%, and 3.66% respectively as average annual returns. Even investing aggressively 100% in equities was not able to match our more conservative and diversified asset allocation approach, which also avoided two major bear markets where prices dropped more than 40% (2000-2002 and 2008-2009).

Reducing volatility is especially critical for those who rely on their portfolio for cash flow. Let’s examine how this would have worked out for a couple retiring in 2000.

We’ll assume the following:

  • Bob and Linda were 60 in 2000.
  • Bob was a lawyer and Linda a dentist.
  • Their portfolio was $4 million in 2000, evenly divided between the two of them. Bob’s portfolio was a traditional balanced portfolio, similar to that offered by the Canadian banks, fund companies and investment counsellors (Morningstar Canadian Neutral Balanced Fund Index), while Linda’s portfolio was with Nicola Wealth in our diversified model portfolio (Nicola Core Composite return).
  • They had been told they could a safely withdraw 4% per year of their portfolio without shrinking their capital and that they should be able to index those withdrawals to inflation (CPI).

The table below shows how they have done since 2000. Here are the key takeaways:

  • Both start with $2 million in 2000.
  • Both take out 4% of their capital in year one ($80,000) and index that to the CPI annually. By the end of 2018 they had each withdrawn $1,827,245 from their portfolios.
  • Bob’s residual portfolio was worth $1,711,732 at the end of 2018, and when combined with his annual income he has a total of $3,538,976.
  • Linda’s residual portfolio was more than double Bob’s at $3,740,687, and combined with her annual income she has a total of $5,567,932.  This is more than $2million more than Bob, or a 57% increase.
  • Linda achieved her results with 30% less volatility than Bob. In 19 years Linda’s portfolio had a (minor) loss in only 2 years, where Bob’s portfolio suffered losses in 6 calendar years, including a 16% drop in 2008.  The key to building wealth is not to lose it in the first place.

Our first “Annus Horribilis” newsletter was written in early 2002. At that time we wrote the following:

So where should your funds be invested for 2002?

If you have been following our advice, then where you are is where you should be.  The fact that a new year is upon us has nothing to do with investment choices, proper asset allocation, or tax planning.  If changes are needed, they should be made after a full review and only when it makes sense in relation to your long-term strategy.

“In the year 2001, our average client had a net return of 3.5% after all fees.  This was far better than the average equity index or balanced fund.  We feel this was possible because most of you accepted our advice to invest in “cash flow” assets.  We firmly believe that these will be the places to stay while “average” equity prices remain expensive.

17 years later, our advice remains the same.

 

Disclaimer:

Nicola Wealth Management is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.

All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances.

“This material contains the current opinions of the presenter and such opinions are subject to change without notice. This material is distributed for informational purposes only and is not intended to provide legal, accounting, tax or specific investment advice. 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. Returns are not guaranteed.”

The Nicola Wealth Core Composite:

The Nicola Wealth Core Composite returns represent the total returns of Canadian dollar denominated accounts of all fee-paying portfolios with a Nicola Wealth Core mandate. The composite includes clients who are both fully discretionary and nondiscretionary. Historical net of fee composite performance returns are calculated using individual realized time-weighted client returns net of fees and is presented before tax. The Nicola Wealth inclusion policy is based on clients’ weights at calendar month end. The composite returns are asset-weighted based upon ending monthly market value. The Nicola Wealth Core mandate may change throughout time. Additional information regarding policies for calculating and reporting returns is available upon request. The composite returns presented represent past performance and is not a reliable indicator of future results, which may vary. Nicola Wealth Core Portfolio past performance is not indicative of future results. Returns are net of fund expenses. Please refer to the Nicola Wealth Funds disclosure document for additional details and important disclosure information. The Nicola Wealth Core Portfolio Fund Asset Mix takes into consideration only the primary asset class of the aggregated funds but does not take into consideration the underlying fund’s holdings of other asset classes. For example, the Nicola Wealth Primary Mortgage Fund is allocated in its entirety to “Mortgages” even though it holds some “Cash.” This investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Client returns are net of Nicola Wealth portfolio management fees. 

This investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity.

Hypothetical performance results have many inherent limitations, only some of which are described below. No representation is being made that any account will or is likely to produce profits or losses similar to those shown. In fact, there are frequent sharp differences between hypothetical performance results and the actual results subsequently produced by any particular trading approach.

1) Hypothetical performance results are limited in that they are generally prepared with the benefit of hindsight.

2) Hypothetical trading does not involve financial risk and no hypothetical trading record can completely account for the impact of financial risk in actual trading. The ability to withstand losses or adhere to a particular trading program in spite of trading losses are material points which can adversely affect actual trading results.

3) Numerous other limiting factors related to the behavior and performance of markets in general and/or to the implementation of any specific trading approach cannot be fully accounted for in the preparation of hypothetical performance results all of which can adversely affect actual trading results when compared to the hypothetical model.