By Rob Edel, CFA
Highlights This Month
- Volatility is notably favourable this month.
- Q1 2017 shows a slowing U.S. economy as consumer spending drops.
- Trump goes for low hanging fruit: tax cuts over tax reform.
- Will “voodoo economics” help boost economic growth?
- Despite a weak first quarter, the Fed still plans to raise rates in 2017.
- The first quarters are the worst quarters.
- Things are looking up for the Eurozone.
- Oil prices are beating up the Canadian dollar.
- Economic growing pains: when real estate dominates the Canadian economy.
The NWM Portfolio
Returns for the NWM Core Portfolio Fund increased 1.8% for the month of April. 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.
Canadian and U.S. yields both flattened last month with 10-year yields falling more than 2-year yields. The NWM Bond Fund benefitted from the decline in interest rates, increasing 0.6%.
NWM High Yield Bond Fund returned +2.0% in April and +3.6% year-to-date, in line with high yield index returns. High yield credit spreads are now narrowing back close to the tightest post-financial crisis levels of 2014. The general search for yield in credit markets means market flows have been less discerning between good versus mediocre credits, resulting in low dispersion across bond yields. Overall, we do not see 5.65% “high” yield as adequate compensation for the credit risk of leveraged companies. As such, the NWM High Yield Bond Fund and its managers remain conservatively positioned—still generating some yield for our investors, but staying lower duration and beta, waiting to reposition opportunistically at better valuations.
Global bond returns were also strong last month, with the NWM Global Bond Fund returning +3.0%. Most of the gains were a result of favorable foreign exchange positioning due to stronger emerging market currencies versus a weak Canadian dollar.
The mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage and the NWM Balanced Mortgage both returning +0.4% in April. 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 and 5.2% for NWM Balanced Mortgage Funds. The primary fund ended the month with cash of $7.9 million, or 4.8%. The balanced fund ended the month with $80.1 million in cash or 16.5%.
The NWM Preferred Share Fund returned -0.5% for the month of April while the BMO Laddered Preferred Share Index ETF returned -0.1%. The ETF finished the month trading at a 0.3% premium to its net asset value, creating a slight valuation gap between the ETF price and the price of its underlying holdings. The negative month was the first since November last year for the fund and marks a transition as investors took profits and repositioned portfolios. Many investors continue to sit on excess cash ready to deploy, but volatility in the 5-year Government of Canada yields (hitting a peak of 1.3% mid-March before ending the month around 1%), has led investors to switch into high reset issues, preferred shares that are trading around yield to call, and perpetual. We are underweight in this space as we believe that several of these names have a limited upside given they trade above par, have extension risk if the issuer extends versus redeems and have more sensitivity to repricing with the new issuance market.
Canadian equities were stronger in April, with S&P/TSX up 0.4% (total return, including dividends). The NWM Canadian Equity Income Fund returned 1.0%, with strong contributions from materials, consumer discretionary, and energy sectors. Our underweight position in telecommunications detracted from performance.
The NWM Canadian Tactical High Income Fund gained an even stronger 1.9%, with the float contributing 0.6%. The fund still maintains a low net equity exposure (current delta adjusted exposure 31%). There were no new positions in the NWM Canadian Equity Income Fund, while the NWM Canadian Tactical High Income Fund added a new short put position in Westshore Terminals.
Foreign equities were also stronger in last month, with the NWM Global Equity Fund up 4.8% compared to a 4.2% increase in the MSCI All World Index and a 3.7% rise in the S&P 500 (all in Canadian dollar terms). Of our external managers, all had positive returns last month, with Pier 21 Carnegie +6.1%, Lazard Global +5.0%, Edgepoint +4.6%, Pier 21 Value Invest +4.2%, and BMO Asia Growth & Income +3.8%, and our new internal EAFE Quant investments returned +4.9%.
NWM U.S. Equity Income Fund increased 1.4% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.1% versus a 1.0% increase in the S&P 500 (all in U.S. dollar terms). In the NWM U.S. Equity Income Fund, we established positions in General Growth Properties and Nvidia Corporation. As for the NWM U.S. Tactical High Income Fund, a new long position was established in General Growth Properties.
Real estate was stronger in April the NWM Real Estate Fund up 1.7% versus the iShares REIT Index +1.4%.
The NWM Alternative Strategy Fund was up 1.7% in April (these are estimates and can’t be confirmed until later in the month) with Winton +1.6%, Citadel +3.3%, Millenium +2.8%, and Brevan Howard +2.2%. We are still in the process of redeeming from Brevan Howard. Of our other alternative managers, RP Debt Opportunities was +0.8%, Polar North Pole Multi-Strategy +0.1%, and RBC Multi-Strategy Trust was flat. Precious metals stocks were weaker last month with the NWM Precious Metals Fund -1.5% while gold bullion was up 2.5% in Canadian dollar terms.
April In Review
Depending on geography, markets ranged from good to bad in April. The good was Europe, with the STOXX Europe 600 Index up 2.1% in local currency terms (Euros) and +6.8% in our lowly beaten-up Canadian dollar terms. The bad was China, with the Shanghai Composite down 2.1% in local currency, but still up 0.3% in Canadian dollars. In the middle, with what we will characterize as mediocre returns, was the U.S. and Canadian equity markets, with the S&P 500 up 1.0% in local currency terms (U.S. $’s) and +3.7% in Canadian dollars, and our own S&P/TSX +0.4%. Mediocre is a relative term, of course, and U.S. markets were less mediocre than Canadian stocks. The technology-heavy NASDAQ, in fact, was up 5.0% in Canadian dollars and topped the 6,000 level for the first time last month, 17 years after reaching the 5,000 point milestone during the dot-com bubble of the early 2000’s.
While U.S. and Canadian stock performance may have been unremarkable, or as we have described it, mediocre, stock volatility continues to be very remarkable. Despite increased uncertainty, especially from a geopolitical perspective, stock volatility remains near all-time lows. Even after big shocks, like Brexit, market corrections have been shallow and short.
Of course, low volatility has been typical of the post-U.S. election rally. With the economy in recovery mode even before the election and the prospects of President Trump’s policies adding even more growth, market risk has been skewed to the upside. Leadership last month, however, was not typical. Rather than a broad rally led by smaller domestic-oriented companies that would stand to benefit the most from the Donald’s pro-American policies, investors appeared to chase a handful of large growth stocks whose earnings would likely continue to increase even if Trump fails to get any of his policies past Congress. It wasn’t a stronger economy that markets appeared to begin pricing in, but an increased chance of a recession, with copper prices and bank stocks falling, and shares of utility companies rising.
Nowhere is the market’s apprehension more evident than in the bond market, where 10-year U.S. treasuries peaked on March 13th at 2.63%, levels not seen in over two and a half years, before falling to 2.17% by mid-April and ending the month at 2.28%. Given the short end of the yield curve is heavily influenced by the Federal Reserve and their loose monetary policy, the fall in longer term treasuries also had the effect of flattening the yield curve, which is typically a bad omen for the economy.
The Federal Reserve is still guiding towards two more rate increases in 2017, but doubts are starting to creep into the market expectations. Lower interest rates also took some of the luster off the U.S. dollar, with Goldman Sachs reserving their previous bullish call on the greenback.
So is the economy really slowing? Well, according to first quarter GDP growth it is. The U.S. economy managed to expand at only a 0.7% annual clip in January through March, mainly due to slower consumer spending. Despite rising stock prices, low unemployment, and high consumer confidence, consumers were unusually frugal the first few months of the year. Temporary issues, like a warm winter which resulted in lower power demand (less need for heating), and delays in tax refund cheques from the IRS hurt results, but a slowdown in the sales of big-ticket items, like cars and refrigerators, is harder to explain. Durable good sales, in fact, suffered their worst decline in nearly six years and car dealers, who have benefitted from a seven-year run in growth, are sitting on a 72 day supply of inventory versus only 66 days a year ago. Also unsettling is the apparent slowdown in bank lending, with commercial loans and leases up just 3.8% over the past year. While the pullback is concerning, economic forecasters are quick to point out that it’s not unusual for first quarter growth to disappoint; as the past eight years have seen the U.S. economy expand at an average 1% pace in the first quarter before growing at 2.3% the rest of the year.
Also unsettling is the apparent slowdown in bank lending, with commercial loans and leases up just 3.8% over the past year. While the pullback is concerning, economic forecasters are quick to point out that it’s not unusual for first quarter growth to disappoint; as the past eight years have seen the U.S. economy expand at an average 1% pace in the first quarter before growing at 2.3% the rest of the year.
Also unsettling is the apparent slowdown in bank lending, with commercial loans and leases up just 3.8% over the past year. While the pullback is concerning, economic forecasters are quick to point out that it’s not unusual for first quarter growth to disappoint as the past eight years have seen the U.S. economy expand at an average 1% pace in the first quarter before growing at 2.3% the rest of the year.
The stronger job market definitely contributed to the recent rise in consumer confidence, but the prospect of President Trump’s pro-growth election promises further boosting the economy has also been a major catalyst. But the Donald’s effectiveness as a politician and the market’s view on his ability to get things done has taken a hit during his all-important first 100 days in office, with healthcare reform stumbling before the House of Representatives finally approving a bill in early May.
This early disappointment increased pressure on Trump to get a victory on something, and tax reform appears to be his current target. Well, tax cuts are probably more accurate, because Trumps’ plan doesn’t focus much on actual tax reform. Who can blame him, tax reform can get a little controversial, but who doesn’t like paying less tax? Surely he can get Republicans to rally together on a plan to cut taxes. The President didn’t release a full plan; rather it was more of an outline light on technical details. The headline grabbing features included a reduction in the corporate tax rate from 35% to 15% and a rollback of the individual tax rate increases enacted under the Clinton and Obama administrations. While the Donald can point to the success of previous tax cuts to sell the plan, especially those during the Reagan administration, government debt was lower and growth more robust back in the Gipper’s day.
The only way tax cuts of this magnitude can be justified in today’s slow-growth-high-debt world is if the cuts themselves actually create stronger economic growth. With The Committee for a Responsible Federal Budget claims the total package would cost about $5.5 trillion in lost revenue over the next 10 years and the Congressional Budget Office projecting federal debt as a percentage of GDP will increase from 75% presently to more than 110% over this time period. Only if the tax cuts lead to stronger economic growth, which in turn generates higher than expected tax revenue, would financial disaster be averted.
This is what happened with the Reagan tax cuts and is the theory put forth by Trump’s Treasury Secretary, Steven Mnuchin. Mr. Mnuchin believes the tax cuts could help produce sustained GDP growth of 3% versus the 1.8% presently forecasted and would largely pay for the cut in corporate taxes, though not the cut in personal tax rates. Naturally, Trump is even more optimistic and claimed at times during the election campaign that if elected, he would not only balance the budget, but he would wipe out the entire $19 trillion U.S. debt in eight years.
Referred to as “voodoo economics” by George H.W. Bush, the linkage between tax cuts and economic growth is hotly debated, with many economists believing the two are unrelated. Past tax cuts in Canada and Britain failed to deliver the expected economic growth, though it’s hard to rule out what other factors caused the disappointment.
Harvard professor N. Gregory Mankiw falls somewhere in between the two extremes and believes that while the benefits of tax cuts may be exaggerated, so are the budgetary costs. Professor Mankiw believes that as a reasonable rule of thumb, faster economic growth should pay for about a third of the cost of a tax cut. Other studies have shown a positive impact on investment, but not on national growth. Regardless, expect markets to react favorably if tax cuts become more likely, and put off worrying about the implications of higher debt to a later date.
For its part, the Federal Reserve isn’t waiting for tax cuts, or any other Trump’s other policies, before continuing to increase interest rates. The Fed believes the weakness seen in the first quarter is temporary and it still plans to raise rates two more times in 2017, with the next increase likely taking place next month. In addition to continuing to raise rates, the Fed has also started to discuss plans to begin shedding their bloated balance sheet of the $4.2 trillion of treasuries and mortgages accumulated during their quantitative easing programs. The Fed’s timing could be interesting if they start to sell the same time U.S. government budget deficits increase as a result of Trump’s tax cuts. The bond market may find it hard to digest all this supply at one time and could result in yields moving higher than desired.
We agree with the Federal Reserve that the slowdown in economic growth is temporary. Stronger economic growth is no longer just a U.S. story, it’s global, and this should take some of the burden off of the U.S. economy. The Brookings-FT Tiger Composite Index shows the recovery has become broad based, with advanced and emerging economies showing growth. The IMF recently moved up its forecast for global growth by 0.1% to 3.5%, despite keeping their 2.3% forecast for U.S. GDP growth this year unchanged. In fairness, the IMF has been overly optimistic the past five years.
The Eurozone is looking particularly strong, with first quarter GDP growth of 1.8% soundly trouncing the U.S.’s 0.7%. Some economists predict the Eurozone economy could grow nearly 2% this year. The Purchasing Manager’s Index has also pushed higher and now stands at a six-year high while consumer sentiment is near levels not seen since 2007.
European political uncertainty has also eased, with Emmanuel Macron topping the polls in first round voting for France’s Presidential election and soundly trouncing far-right anti-Euro candidate Marine Le Pen in the subsequent two-person runoff. Next up is the June 8th general election in the UK, where the ruling Conservative Party presently commands a 20 point lead over the Labour Party. Of course, the Brexit negotiations with the EU remain an overhang, but so far the impact has had a muted impact on the British economy. Eurozone stocks and the Euro have benefitted from the positive economic and political environment, as could be seen by the strong returns in the STOXX Europe 600 Index last month.
One of the reasons economic growth in the Eurozone and the rest of the world has been stronger has been because of China. According to UBS, Chinese imports grew 15% last year and China accounted for 27% of total global investment last year, far outpacing their 15% share of the global economy. Unfortunately, much of China’s growth last year was fueled by debt and China’s central bank has started to tighten credit. In addition, Chinese authorities have rolled out a host of measures aimed at curbing risk in China’s financial system ahead of the 19th National Party Congress scheduled to take place this autumn. Chinese President Xi Jinping, who is expected to sign on for another five years, doesn’t want any surprises, like a debt crisis upsetting the transition in leadership and has directed finance officials not to miss “a single risk” or “hidden danger”. Chinese stocks have sold off, anticipating that tighter credit would lead to slower growth, but strangely the global market, and emerging economies, in particular, have not.
Apart from China, one of the weakest markets last month was in fact Canada. Unlike China, however, tighter credit wasn’t the issue. Concerns over lower oil prices, fears of Donald Trump tightening the screws on trade, and the housing market, are what had Canadian investors nervous. There is a fairly strong positive correlation between the price of oil and the Canadian dollar, and the fall in crude prices took a toll on the loonie last month. A glut of gasoline was likely the culprit as refiners took advantage of high refining margins and produced gasoline and diesel at the highest rate in more than 34 years. Lower prices should lead to increased demand and a more balanced market later in the year. We still believe oil prices need to move higher given lower future supply from non-OPEC and non-U.S. shale oil sources.
Also hurting the Canadian dollar and Canadian stocks were concerns President Trump may press for more than just small tweaks to NAFTA as he verbally attacked Canada’s dairy industry and the U.S. Commerce Department levied preliminary duties on softwood lumber exports. The softwood lumber duties, while unpleasant, were not unexpected and were in the works long before Trump was elected. Higher lumber prices had already more than offset the tariffs and Canadian lumber stocks are actually been moving higher.
As for the comments directed at Canada’s dairy industry, we view it as the beginning of the negotiating process. Yes, Canada has a lot to lose from a trade war with the U.S., but there are a lot of states that depend on exports to Canada as well, and many of them voted Republican in the last election. We still believe Canada is not in Trump-trade crosshairs.
As for the housing market, Canadian financial stocks were rattled last month after the Ontario Securities Commission launched proceedings against alternative mortgage lender Home Equity. The fallout from the news resulted in a sharp correction in Home Equity’s stock price and a run on its deposit base. Many feared a contagion to the rest of the mortgage market, which short-sellers had been negative on for years.
While the problems at Home Equity appears company specific, the sharp rise in home prices, especially in Vancouver and Toronto, do put increased risk on the Canadian economy. Higher interest rates and a rise in unemployment are typically the catalysts for a housing correction, and we don’t see either of these in the near term. As a percentage of the total economy, however, residential construction and real estate related industries in general presently represent an outsized share of the economy and we fear the inevitable reversion to the mean could present a sizable headwind to future economic growth in Canada.
Overall, a noisy month, but we think the global economy is still on track. We like the fact that European and emerging markets did well last month, but we don’t think this is sustainable if U.S. growth falters. Fortunately, we believe the recent softness in first quarter U.S. growth, like last year, is temporary and should pick up the rest of the year.
In addition, any progress President Trump is able to make on his pro-growth policies would provide even more upside to growth. China’s growth should moderate, but we don’t see any crisis for at least the next year. A slowdown in Chinese growth will be more of a headwind for Europe and emerging market economies than the U.S. economy, or Canada for that matter. We continue to worry about the housing market in Canada, but higher oil prices and a stronger U.S. economy should help keep the Canadian economy growing.
What did you think of April’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.