February in Review: A Balancing Act on a Thin Wire.


By Rob Edel, CFA

Highlights This Month

    • The strong start to the year is not indicative of the current business cycle
    • Non-residential fixed investment decelerated providing a mixed picture for capital spending.
    • The economy has slowed and first quarter GDP growth estimates are coming down
    • Chinese and U.S. stocks have been soaring on news progress has been made between U.S. and Chinese negotiators.
    • The Eurozone is shaping up to be the weak link in the global economy and could be the first region to slip into recession

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      Nicola Wealth Management Portfolio

      Returns for the Nicola Core Portfolio Fund were up 1.2% in the month of February.  The Nicola Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of Nicola Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

      The Nicola Bond Fund returned +0.6% in February as Canadian investment grade credit spreads continued to tighten from their late 2018 levels. The Nicola Bond Fund currently has a net yield of 2.9% and interest rate duration of 1.8 years.

      The Nicola High Yield Bond Fund returned +0.9% in February, and is +1.4% year-to-date. After outperforming the general high yield bond market during the volatile end of 2018, it has not kept up so far this year with the market’s strongest two-month start in two decades. The BoAML US High Yield Index yield has decline from its year-end high of 8.0% back down to 6.6%. The overall Nicola High Yield Bond Fund currently has a net yield of 5.5% and duration of 2.5 years.

      The Nicola Global Bond Fund was up 0.5% for the month. Returns were driven by our exposure to the Templeton Global Income Fund and PIMCO Monthly Income Fund, which were up 2.7% and 1% respectively. Templeton Global Income Fund is a closed-end fund that has historically traded at a significant discount to its net asset value. Over the last several months the discount has narrowed from 15% to 11% providing a tail wind for performance. Exposure in investment grade and high yield credit were the largest contributors to returns for the PIMCO Monthly Income Fund as select exposure in financials and industrials benefitted from the continued risk asset rally with credit spreads tightening and interest rates rising modestly.

      The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.3% and +0.5% respectively last month. 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 4.0% for the Nicola Primary Mortgage Fund and 5.4% for the Nicola Balanced Mortgage Fund.  The Nicola Primary Mortgage Fund had 21.5% cash at month end, while the Nicola Balanced Mortgage Fund had 15.7%.

      The Nicola Preferred Share Fund returned 2.1% for the month while the BMO Laddered Preferred Share Index ETF returned 1.8%.  The strong returns were assisted by the reduction of supply in the market as $1 billion of preferred shares was returned to clients through the redemption of multiple classes of Royal Bank and Westcoast Energy shares. Despite strong returns, retail sentiment continues to be weak in the market noted by high net redemptions of over $120 million from preferred share.

      Canadian Equities continued to rebound in February. The S&P/TSX was +3.1% while the Nicola Canadian Equity Income Fund was +3.0%. Top contributing sectors were Industrials, Consumer Discretionary, and Financials. Negative contributing sectors were Information Technology, Materials, and utilities. We do not have exposure in Information Technology or Utilities where valuations are high and value is slim. We did not add or subtract any names in the month. Top contributors to performance were Heroux-Devtek, Cargojet, and Air Canada. Top detractors were Interfor, Teck Resources, and Aritzia.

      The Nicola Canadian Tactical High Income Fund returned -0.1% vs the S&P/TSX’s +3.1% return.  The Nicola Canadian Tactical High Income Fund’s relative underperformance was due to being underweight Energy, Info Tech, Real Estate and Utilities and stock selection within the Communication Services and Industrials & Materials sectors. As the market continued to grind higher, the market participants became more complacent and less concerned about market risk as shown by the decline of 17.7% in the Canadian option volatility index.  The Nicola Canadian Tactical High Income Fund was still able to earn high single-digit Put option premiums and double-digit downside protection on select names.  The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 66% (similar to January) and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market. Aritzia and Alimentation Couche-Tarde (previously owned names) were reintroduced to the portfolio.

      The Nicola U.S. Equity Income Fund (USD$) returned 2.4% during February, trailing the S&P500, which returned 3.2%.  Underperformance was driven by declines in Newell Brands and energy names Valero and EOG Resources, which more than offset gains from Estee Lauder, Visa, and not owning Amazon.com or Facebook.  Apart from reversing tax loss trades, there were no new names introduced to the portfolio, nor were any eliminated.  We trimmed back our Bank exposure and took some profits on EA, and added to laggards including Apple, Home Depot, and Costco

      The Nicola U.S. Tactical High Income Fund (US$) returned 2.9% vs 3.2% for S&P 500.  The relative underperformance was mostly due to being underweight in info tech & industrials and stock selection within energy & consumer staples.  Option volatility decreased 10.8% during the month to the sub-15 level, which puts it back to Q3 2018 levels.  We were still able to generate double-digit annualized premiums with double-digit break-evens.   The Nicola U.S. Tactical High Income Fund’s delta-adjusted equity decreased from 56% to 52%. The portfolio remains defensively positioned with a lower valuation multiple, and higher free-cash-flow and lower leverage relative to the S&P 500.

      The Nicola Global Real Estate Fund was +1% for the month of February vs. the iShares (XRE) +3.9%. Currently, 39% of the fund is allocated to U.S. denominated LPs. Publicly traded REITs make up 22% of the fund which is near the low end of our range. We added H&R REIT and Brookfield Property Partners to the portfolio this month and are in the process of selling our allocation to the Nicola U.S. Real Estate Fund over the next several months.

      We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of February 28th January performance for the Nicola Canadian Real Estate LP was -0.2%, Nicola U.S. Real Estate LP +1.0%, and Nicola Value Add LP 0.0%.

      The Nicola Alternative Strategies Fund returned 0.8% in February (these are estimates and can’t be confirmed until later in the month).  Currency contributed 0.2% to returns as the Canadian dollar weakened slightly through the month. In local currency terms, Winton returned 0.6%, Millennium 0.3%, Apollo Offshore Credit Strategies Fund Ltd 0.2%, Verition International Multi-Strategy Fund Ltd 0.7%, Renaissance Institutional Diversified Global Equities Fund -0.7%, RPIA Debt Opportunities 0.8%, and Polar Multi-Strategy Fund 1.1% for the month. Return drivers for the different strategies was well balanced. In Winton, commodities, currencies, and stock indices added value. Specifically, short positions (positions that are profitable when the investment price declines) in wheat, coffee, corn and soybeans all were strong contributors to returns.

      The Nicola Precious Metals Fund returned 1.4% for the month while underlying gold stocks in the S&P/TSX Composite index returned -1.7% and gold bullion was lower -0.3% in Canadian dollar terms. The month marked a period of strong returns for smaller cap names such as Atlantic Gold, Semafo, Regulus Resources, and Osisko which all returned more than 20% each supporting returns for the overall fund despite a weaker gold price.

      February in Review

      Most asset classes were strong last month, with equities, fixed income, and real assets all providing positive returns.  Equities continued their strong run since hitting lows just before Christmas, with the Dow Jones Industrial Average, NASDAQ, and Russell 2000, all going on to post gains in excess of over 20%, thus moving back into bull market territory.

      The large cap S&P 500 got within a whisker of the 20% mark itself in early March, but then it also avoided slipping into a bear market on December 24th by an equally slim margin.  The Canadian S&P/TSX also provided solid returns in February, but like the S&P 500, never officially fell into a bear market last year so the fact it has failed to rally more than 20% is of less consequence.

      The S&P/TSX rose 3.1% in February and is up a very respectable 12.1% in the first two months of the year.  Same for the S&P 500, which gained 3.2% in February and 11.5% year to date (in local currency terms).  Looking more closely at the makeup of returns within the S&P 500 since the December 24th lows, traditionally economically sensitive sectors, such as industrial, energy, technology, consumer discretionary, and financials, have all outperformed.  European stocks did even better than Canadian or U.S. stocks last month, but it was Chinese equities that really stood out, with the Shanghai Composite up 13.8% in February and +17.9% year to date (in local currency terms).  Fixed Income returns were also strong, as were commodities such as oil, nickel and copper.

      Based on these returns, one might assume it’s been all smooth sailing so far this year, which would be quite a change from the bumpy ride at the end of last year.  In reality, however, current market conditions could be best described as more of a balancing act.  While the two main factors causing market angst late last year, namely Fed tightening and U.S. China trade war fears, have been greatly reduced, both still remain threats in the coming months.  The Federal Reserve is on hold in regards to raising rates and the U.S. and China appear on track to settle their trade differences, leaving investors left to determine how much of this good news is now discounted in the market.

      The Fed is on hold because of concern over slowing economic growth, which paradoxically is being taken as a good thing by investors.  Investors appear to prefer the economy to be “just right”, but if they have to choose between the two extremes, they would choose an economy that is “too cold” rather than an economy that’s “too hot” and prompts the Fed to continue raising rates.  Too much of a good thing (or in this case too much of a bad thing) rarely ends well, however, and investor sentiment is likely to take a turn for the worse if the economy were continue to slow.

      As for the U.S. – China Trade war, we’ll wait to see what the final agreement is before drawing any hasty conclusions, but we doubt any agreement will resolve everyone’s grievances.  In 1991, the last time the S&P 500 managed to increase more than 10% in the first two months of the year, the index went on to add another 14% over the remaining 10 months.  The other five times the S&P 500 got off to such a good start, however, the remaining 10 months saw returns of less than 10%, with 1987 and 1931 standing out as particularly nasty years.

       

      The strong start to the year is not indicative of the current business cycle.

      We don’t think the rest of 2019 will be quite that bad, but we also don’t think the strong start to the year is indicative of where we are in terms of the current business cycle and the underlying fundamentals.  Below, we take a close look at these issues, and more.

      Starting with the U.S. economy, the news is mixed.  Economic growth is slowing, but it’s not contracting.  U.S. fourth quarter GDP came in at better than expected +2.6%, which was lower than Q3’s 3.4% growth rate and Q2’s 4.2% increase, but compared to Q4 of last year, the U.S. economy is 3.1% larger, which is not too bad.

       

      Non-residential fixed investment decelerated providing a mixed picture for capital spending.

      Non-residential fixed investment (business investment on software, research and development, equipment and structures) was up 6.2% over the previous quarter, but new orders for nondefense capital goods excluding aircraft  (manufactured goods intended to last at least three years) decelerated in December for the fourth time in five months, thus providing a mixed picture for capital spending.  Capital spending is a key indicator because higher business investment is instrumental in helping to extend the business cycle.

      The difference between the two capital spending releases is indicative of the confusion prevalent in economic releases last month and is probably a result of the record 35 day partial government shutdown that extended into January and impacted the collection and reporting of economic data.   December retail sales, for example, suffered its largest decline in nine years despite retailers announcing generally strong same store sales. Likewise, industrial production fell in January, despite a strong manufacturing sector. Along with reporting issues, a colder than normal winter could also be partly responsible for some of the weakness.

       

      The economy has slowed and first quarter GDP growth estimates are coming down. 

      The housing market, in fact, has been showing the effects of a slowing economy for most of 2018.

      Along with a slowing economy, investors have had to contend with the prospect of slowing corporate earnings.  Despite the bounce back in equity prices in January and February, analyst earnings estimates have been moving in the opposite direction with more and more talk in the media about an “earnings recession”.  Like the economy, earnings growth might be slowing, but it doesn’t mean they are going to contract.

      An earning recession also doesn’t necessarily mean we are headed for an economic recession, as BMO’s Investment Strategy Group  recently pointed out, highlighting the fact that four of the past six earnings recessions didn’t coincide with an economic recession.  A strong U.S. dollar combined with the positive effects of last year’s tax cuts will naturally dampen growth from last year’s torrid pace, but a strong job market and optimistic consumer has largely left companies in a strong position.

      Balancing out weaker economic and earnings growth late month has been the growing belief in the market that the Federal Reserve is done raining rates and their next move is now more likely to be a rate cut than a hike. This pivot by Chairman Jerome Powell has not only helped push stock prices higher, but has resulted in a sharp easing in U.S. financial conditions such that they are once again the easiest amongst the major economies tracked by Bloomberg.

      Of course this might be warranted if the U.S. economy was on the verge of sliding into recession.  According to Oxford Economic, in four of the past nine recessions, there was only a two quarter lag between the end of the Fed’s tightening cycle and the following recession. If indeed the Fed is done raising rates, a recession might be less than six months away.  The market is clearly not discounting this given the strong rally to start the year.  Nor are we.

      In fact, we are not convinced the Fed is done raising rates.  While we expect them to be “patient” in the first half of the year, if the economy and the stock market continue to gain traction, we expect the tightening cycle to continue.

       

      The key economic number to watch, in our opinion, is inflation. 

      Despite unemployment falling to historically low levels, inflation has remained stubbornly below the Fed’s 2% target level. The past three economic expansion cycles, in fact, have seen inflation trend progressively lower on average.  Also trending lower has been the Federal Reserve’s estimate of the neutral rate, the overnight interest rate that is neither restrictive nor simulative. Presently, the Fed believes the neutral rate lies somewhere between 2.5% and 3.5%, meaning at the lower end of the band, the Fed could already have reached neutral.  If neutral is only 2.5%, however, and the Federal Reserve is done tightening, they don’t have much room to cut rates in the next recession, especially given past recessions have seen the Fed cut overnight rates by 5% on average.  Ideally, the Fed would like to see inflation trend higher giving them cover to keep raising rates and store a little more dry powder for the next recession.  Even in the absence of inflation, the market is likely a bit ahead of itself in thinking a rate cut is close by.

      According to exchange traded fund (ETF’s) flows, fixed income investors appear to believe inflation risks have virtually disappeared and bond yields will remain low for the foreseeable future. Net flows into inflation protected securities (TIPS) have evaporated and are on track to post outflows , and investors have been selling short and ultra-short term bond ETF’s.  Investors prefer to hold shorter term bonds when the Fed is tightening given higher rates mean lower bond prices.

       

      When the Fed isn’t tightening, long term bonds are more attractive. 

      The belief in a “patient” Fed has also resulted in lower volatility in the Treasury market.  Interestingly, the decline in Treasury yields is at odds with market action in the high yield bond market, where yields have also been falling.  If treasury yields are falling because the economy is slowing and heading into recession, credit spreads should be widening, not falling.  Again, it’s a balancing act for investors.

      Interest rates are falling because investors feel the Fed’s in a holding pattern and won’t continue to raise rates and drive the economy into recession.  This fear is what moved credit spreads higher at the end of last year.  But investors don’t feel the economy is slowing enough such that we are headed into a recession, at least not quite yet.  They appear to believe the economic conditions are “just right”.  Again, it’s a fine balance the market appears to be pricing in.

       

      Chinese and U.S. stocks have been soaring on news progress has been made between U.S. and Chinese negotiators.

      Same for the prospects of a trade deal between the U.S. and China.  Chinese and U.S. stocks have been soaring on news substantial progress has been made in talks between U.S. and Chinese negotiators with President Trump indefinitely suspending the planned increase in tariffs on $200 billion of Chinese goods from 10% to 25% that were scheduled to kick in at the end of the month.

      Again, the question for markets is how much of this good news has already been discounted in the market.  Both leaders need a deal.  Trump, because he didn’t get his wall or a deal with North Korea, and China’s President Xi because the Chinese economy looks to have slowed dangerously.  Details of how the deal is shaping up have started to leak out.  China is offering to purchase more U.S. agricultural and energy products, give American companies better access to Chinese markets, and improve the protection of intellectual property rights.  A plan to enforce the agreement is also in the works, which is important given Beijing’s failure to deliver on past promises.

      The U.S. apparently wants to have the right to reinstate tariffs if they believe China is cheating, without China retaliating.  Likely a non-starter for China.  Also still being contested is whether China will agree to curtail the granting of subsidies to domestic companies.  The recent dropping of the “Made in China 2025” policy is a sign Beijing is at least willing to make their support less obvious, but they are unlikely to make any large structural concession in how the Chinese economy functions.   No date has been set for a Signing Summit (Trump loves these kinds of things) so the timing of an announcement is still unclear, as is what will happen with the current 10% tariffs on $200 billion imposed on Chinese imports last fall and the 25% tariffs on $50 billion imposed last summer.

      Not expected to be included in any deal is any decision on the fate of Huawei and its Vancouver confined CFO, Meng Wanzhou.  U.S. negotiators maintain this is a separate issue, though Trump might dangle this out to China in order to get the deal over the finish line.  He is a deal maker you know.  President Trump believes a trade deal with China will move the market higher, and he is probably right.

      Long term, continued friction between the U.S. and China will continue to haunt the markets. 

      Given the bipartisan distrust in Washington towards China, no trade deal will appease all parties and the broader issue of curtailing Chinese economic and geopolitical ambitions will still remain on investor radar screens.  Increased visibility for trade will be good for business investment, but the nationalistic trends in place well before the current trade dispute are unlikely to be forgotten.

      Of course there is no guarantee of a deal, and if negotiations break down, so will the market.  Regardless, even without a deal yet it looks like China’s economy is improving after enduring what could be described as a slippery uphill climb over a wall of economic worry (see picture below for visual).

      According to Bloomberg, economic indicators have started to turn higher and Chinese leadership has committed nearly $300 billion in fiscal stimulus in 2019.  Investors need look no farther than the strong rise in Chinese stocks to see an inflection point in the Chinese economy might be on hand, with staples and consumer discretionary stocks leading the way.

      One word of caution, prospects for a trade deal with the U.S. is at least partly responsible for the rally in Chinese equities, as is the recent announcement that MSCI will increase the amount of domestic Chinese A shares in its China Benchmark.  According to Goldman Sachs, the change could result in global investors buying $60 billion in Chinese stocks.

      Again, to offer a balancing negative, stimulus is necessary because economic growth in China has slowed, and probably more than Chinese leaders are letting on.  GDP growth last year weakened to 6.6%, slowest in nearly three decades, and is targeted to increase between 6% and 6.5% in 2019.  Even worse, according to the Brooking Institute, the effect of local governments inflating their growth rates has resulted in China’s national growth rate being overstated for years. When looking at official growth rates for the years 2008 to 2016, Brookings suggests shaving off about 1.7%.

      Perhaps Chinese stocks are a bit ahead of themselves, likewise for U.S. and Canadian equities, they are positive in the market and economy to justify at least some of the recovery from last year’s December correction.  Not so much with Europe.  Like North American and Chinese stocks, European equities rallied last month, but the bull case is harder to balance off.

      Funds flowing into equity mutual funds and ETF’s remain negative and the increased spread between U.S. 10 year treasury notes and 10 year German government bonds have widened, indicating doubts regarding the future direction of interest rates and growth in the Eurozone.

      German 10 year bonds, in fact, have retreated to levels last seen in late 2016 and are perilously close to falling below zero once again. European stocks are cheaper than U.S. stocks, however, though not as cheap as they were at the end of 2018.

       

      The Eurozone is shaping up to be the weak link in the global economy and could be the first region to slip into recession. 

      Industrial production is falling at the fastest pace since the financial crisis and the European Commission recently lowered its 2019 growth rate for the Eurozone from 1.9% to a skinny 1.3%.  Politically, Europe is a mess.

      Spain has scheduled a snap election in April, Germany is in the process of a leadership transition, Italy’s unstable antiestablishment coalition is struggling with a banking crisis, France’s economic reforms’ are being met with fierce resistance, and Britain doesn’t know whether they are coming or going.  Literally. All this means the ECB and monetary policy is left to bear the entire burden of stabilizing the Eurozone economy.

      In early March, the ECB announced interest rates will remain at current levels (deposit rate -0.4%) until at least the end of the year, the size of their balance sheet will be maintained, and cheap funding (TLTRO – targeted long term refinancing operations) will be provided to European Banks until 2023.  A stronger Chinese economy and better visibility for global trade could help the Eurozone, especially Germany, who count on China as their largest customer and saw German exports to China fall 7.7% year over year in December.  Even if this is the case, however, returns and growth should favor Emerging Market’s before the Eurozone.

       

      We still favor risk assets such as equities and credit as we believe a recession is still at least a year away. 

      We are cognizant of the dangers, however, to both the upside and downside.  Too much growth and the Federal Reserve is going to continue raising rates.  Too little growth and investors will start to believe the Fed has already tightened too much and the recession has already started.  Quite frankly, we saw signs of both last month and getting the balance just right is going to test investor nerves over the coming months.

      A trade deal between the U.S. and China is a positive, but a lot has already been priced into the market.  There is also the risk the deal doesn’t go far enough, or that the deal doesn’t happen at all.

       

      China’s economy should stabilize, thanks in large part to fiscal stimulus, which will be good for the global economy, even the Eurozone. 

      We wouldn’t be disappointed to see the market take a bit of a breather over the next couple of months as it digests the recent good news and balances out some of the risks still present.

       

       

      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 Nicola Wealth 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 Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth 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. For a complete listing of Nicola Wealth Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg. Effective January 1, 2019 all funds branded Nicola Wealth Management were changed to the fund family name Nicola. Effective January 1, 2019 Nicola Global Real Estate Fund, Nicola Canadian Real Estate LP, Nicola U.S. Real Estate LP, and Nicola Value Add LP adopted new mandates and changed names from Nicola Real Estate Fund, SPIRE Real Estate LP, SPIRE US LP, SPIRE Value Add LP