By Rob Edel, CFA
Highlights This Month
- This is now the second longest bull market in history.
- Timing a turn in the market is tricky but we can share one sure thing…
- Trump’s wavering support threatens market performance.
- Will 2017 be the year the Fed can significantly raise rates?
- The long and short-term of it all.
- Who is threatening the future of the Euro?
- The moral of the story: don’t take good news it for granted.
The NWM Portfolio
Returns for the NWM Core Portfolio Fund increased 1.7% for the month of February. The 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.
The Canadian yield curve flattened last month, with 10-year yields declining just over 12 basis points to 1.63% while 2-year yields moved down just over 1 basis point to 0.76% in February. The U.S. yield curve flattened even more, with 10-year yields declining just over 6 basis points to 2.39%, while 2-year yields increased nearly 6 basis points to 1.26%. The NWM Bond Fund was up 0.8%, mainly due to the continuing decline in credit spreads.
Tighter credit spreads also helped high yield bond returns, as did a weaker Canadian dollar. The NWM High Yield Bond Fund returned 2.1% last month.
The weaker Canadian dollar was also a factor for the NWM Global Bond Fund, which increased 3.5% in February. A global rally in bond prices (decline in yields) was also a major contributor to returns last month.
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% in February. 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 4.3% for the primary fund and 5.4% for the balanced fund. NWM Primary Mortgage Fund ended the month with cash of $14.2 million, or 8.5%. NWM Balanced Mortgage Fund ended the month with $54.8 million in cash, or 11.3%.
The NWM Preferred Share Fund was inline with the overall rate reset market, returning 1.3% compared to the BMO Laddered Preferred Share Index ETF at 1.4%. 5-year Canada yields remain unchanged for the month while credit spreads continue to tighten. Although the market has had an incredible run, we are still below peak levels reached in 2014. From a total return perspective, rate resets are still approximately 9% below their 2014 highs; whereas the total preferred share market is still 3% below its highs. Demand for preferred share pooled funds also continues to drive flow dynamics. Over the past three months, three of the largest preferred share ETFs received net inflows of nearly $500 million helping to absorb $1.325 billion in new issuance over the course of the month.
Canadian equities managed only modest returns in February, with S&P/TSX up 0.2% (total return, including dividends). The NWM Canadian Equity Income Fund was up 1.2%, mainly due to having no exposure to the metals and mining sector and a low exposure to oil and gas. Alternatively, our positions in paper and forest products positively contributed to performance given their strong returns last month. The NWM Canadian Tactical High Income Fund also gained 1.2%, with a low net equity exposure (current delta adjusted exposure 38%) and positive float helping returns. In the NWM Canadian Equity Income Fund, we initiated a new position in Aritzia and sold our position in Valeant. In the NWM Canadian Tactical High Income Fund, no new long only positions were added, but a short put position in Aritzia was established.
Foreign equities were stronger in February with the NWM Global Equity Fund up 3.4% compared to a 4.7% increase in the MSCI All World Index and a 5.9% rise in the S&P 500 (all in Canadian dollar terms). Of our external managers, all had positive returns last month, with BMO Asia Growth & Income +4.8%, Pier 21 Carnegie +4.4%, Pier 21 Value Invest +3.8%, Lazard Global +2.5%, and Edgepoint +2.3%. NWM U.S. Equity Income Fund increased 3.9% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.3% versus a 4.0% increase in the S&P 500 (all in U.S. dollar terms). In the NWM U.S. Equity Income Fund, we established new positions in Zimmer Biomet, Boston Scientific, and CR Bard, and sold Stryker and Walgreens. As for the NWM U.S. Tactical High Income Fund, we established a new short put position in Carlisle.
Real estate was stronger in February with the NWM Real Estate Fund up 3.0% versus the iShares REIT index +3.4%.
The NWM Alternative Strategies Fund was up 1.8% in February (these are estimates and can’t be confirmed until later in the month). The weak Canadian dollar provided a tailwind for all our Altegris feeder funds, with Winton +4.3%, Brevan Howard +2.9%, Citadel +2.0%, and Millenium +1.7%. All our other alternative managers also had positive returns last month, with RP Debt Opportunities +1.2%, MAM Global Absolute Return Private Pool +0.5%. Polar North Pole Multi-Strategy +0.5%, and RBC Multi-Strategy Trust +0.2%. Precious metals were stronger with the NWM Precious Metals Fund +0.2% and gold bullion up 5.2%.
February In Review
We barely had time to adjust the fit on our new Dow 20,000 hat when the blue chip index broke 21,000 in early March after rising 5.2% in February. Most global equity markets were strong last month in fact, with the S&P 500 up 4.0% and the MSCI World Index +2.8%.
In Canadian dollar terms, the gains were even more impressive given the 2.2% decline in the loonie. Canadian equities were also higher, but only by a modest 0.2% due to weak returns in the energy and basic material sectors. A stronger global economy was largely responsible for the rally in stocks, with investors positioning their portfolios to take advantage of a reflating economy, but investor optimism over the Trump administration’s pro-growth policies have also helped boost markets, particularly in the U.S.
Not only have equities been moving higher, but they have been remarkably orderly in doing so. The S&P 500 rose 1.4% on March 1st after going 55 consecutive trading days without an intra-day move of more than 1%, either up or down. Declines of more than 1% have been even rarer, with one needing to go back to October 11th of last year to find a fall in the S&P 500 of more than 1%. Since then, the market has risen 11.5% (to the end of February) and is up 10.0% since Trump was elected on November 8th. For 2017 in total, Wall Street strategists were forecasting a 5% gain for the S&P 500. The index surpassed this mark, and more, in the first two months of the year.
Valuations are stretched, but are not unreasonable so, especially when the earning-depressed energy sector is excluded. Also, trading volume is not inflated and margin debt as a percentage of market value remains steady, both of which have historically been good indicators of market bubbles.
BMO Capital Market’s Brian Belski recently pointed out the market has simultaneously crossed 20 times and 20%, meaning it trades at a more than 20 times earnings multiple after climbing more than 20% over the past 12 months, for only the tenth time since 1954. This doesn’t mean stocks can’t keep going higher, however. The previous four times the market crossed 20 times and 20% returns were positive over the following 12 months, with a 26% gain recorded in 1996. For his part, Belski still thinks the current market has room to move higher.
Less optimistically, after turning eight years old at the end of February, the current bull market is now the second longest bull market in history, and individual investors appear to have finally taken notice.
According to EPFR Global, global equity funds posted record inflows during the week ending March 1st based on records dating back to 2000. Increased retail demand could push prices even higher, but individual investors have historically been poor at timing the market and current retail flows could be seen as a potential negative indicator for the market. Also exhibiting a poor track record in timing the market are Wall Street newsletter writers. 63.1% were bullish in early March according to Investor Intelligence, their highest level of bullishness since 1987. Corporate insiders are not bullish, with only 279 insider purchases recorded in January, the lowest since 1988. There are many reasons why insiders sell stock, such as estate and tax planning, but only one reason why they buy.
Timing a turn in the market is tricky, but bull markets don’t typically die of old age; recessions are usually the cause of death. The current economic expansion is now in its 93rd month, the third longest in U.S. history, which may lead one to conclude a recession is overdue. Because growth has been below par during the recent expansion, however, the duration of the recovery might not serve as a good historical reference point.
More optimistically, concerns over deflation have eased as commodity prices, including oil, have started to increase. Purchasing manager indices have also turned higher, not just in the U.S., but in Europe, Japan and China as well. These indices, however, are considered “soft” economic indicators because they are based on surveys and not hard data. Other “soft” indicators like consumer and business confidence have turned higher after Trump was elected and it makes sense these would eventually translate into higher “hard” economic indicators, like GDP growth.
But what if Trump is not able to make good on his campaign promises? Just trying to handicap the odds of Trump actually remaining in power is tough, let alone determining the probability of him actually getting anything done. The market appears to be giving him the benefit of the doubt, but anyone watching CNN or reading a newspaper, especially the New York Times or Washington Post, likely believes the Trump Administration is in total turmoil, jumping from one scandal and crisis to the next. How will Trump be able to deal with a nuclear armed North Korea if he can’t even get his own team on the same page? Forget about the economy and jobs, many fear for the future of humanity in general. What is the market seeing that the media are not?
This disconnect is a risk for the market, though we suspect the issues investors care about may not be the same as those being reported by the mainstream media. Investors believe Trump’s policies can help drive economic growth and news on the likelihood of these policies being enacted is important. The rest is just noise. For example, we don’t care that Kellyanne Conway, currently serving as Counselor to the President, inadvertently endorsed Ivanka Trump’s fashion line. Or how about the pictures of Kellyanne kneeling on a couch in the Oval office with, wait for it, her shoes on! How disrespectful! Why is this news? Yes, Trump doesn’t do himself any favours with his late night “tweets,” and some of what he says is just not true. Even so, there is still the perception among his supporters that Trump “tells it like it is,” and the media does not. Republicans in general believe Trump more than they believe the media, especially when the media doesn’t focus on issues that are important to the American people. It’s a lesson that cost Hilary Clinton the election. When Trump tones down the rhetoric, his approval rating goes even higher, like it did after his recent address to a joint session of congress.
Which of Trump’s policies do markets like? Deregulation and tax reform, particularly corporate tax reform, are two of their favourites and can make a meaningfully positive impact on growth. Deregulation has already started, with Trump declaring two existing regulations be eliminated for every new regulation created. Tax reform is going to take longer. U.S. companies pay too much tax and are incentivized to move their manufacturing offshore.
Changes being proposed are complicated, but necessary and long overdue. Unfortunately, in order to pass tax reform without requiring 60 votes in the Senate (which would require some Democratic support) rather than a simple majority, the Republicans need to pass a budget and include a tax reform “reconciliation” bill as part of the fiscal year 2018 budget process. In order to pass a budget, the costs and tax implications of health care need to be resolved, meaning the ACA (Affordable Care Act) needs to be reformed first. Corporate tax reform is going to be tough, but there is likely a path to some common ground. Health care, not so much.
When told of the Republican plan to quickly repeal and replace Obamacare, former GOP Speaker of the House, John Boehner started laughing and remarked, “Republicans never ever agree on healthcare.” How inspiring. Delays in repealing and replacing Obamacare not only hurts Trump’s credibility given he promised it would be accomplished quickly, but it could delay tax reform, which the market has already started to discount with the recent market rally. Even worse, public opinion has turned against repealing Obamacare, which will make it even tougher to reach a consensus. This is a risk for the market.
Of all Trump’s policies, the one we don’t get is immigration. With an aging population, immigration can help fill the demographic hole being left by retiring baby boomers and help reduce the looming entitlement spending burden. As for undocumented workers, we get the unfairness argument, with illegal immigrants skipping the line while those trying to enter America legally patiently wait their turn. The fact remains, however, most undocumented workers are taking jobs most Americans don’t want, and without them, employers will struggle to find workers to fill these unwanted and low paying jobs. This won’t help economic growth.
While the market is keenly interested in what’s happening inside the beltway (Washington, D.C.), a shift in policy at the Federal Reserve also has the potential to impact investor sentiment. Though the Fed indicated earlier in the year that they planned to hike interest rates three times, or 0.75%, in 2017, investors believe only two hikes are likely, with the first one not coming before May at the earliest. By clearly telegraphing to the street that a rate increase in March was almost a done deal, the Fed has managed to shift expectations for interest rates in the coming months.
The Fed wants to raise rates. Not only do they want regain some credibility after promising 4 increases last year and delivering only one, but they need to provide some room to cut rates in the future if the economy were to slow. Also, despite the fact GDP growth remains below par, the Fed believes the economy is nearing full capacity and the aggressive fiscal policies Trump is planning could cause inflation to spike higher. Already there are signs inflation is nearing the Federal Reserve’s 2% target levels with commodity prices trading higher and investors seeking protection in inflation protected treasury’s (TIPS).
While the stock market has clearly voted in favour of Trump and his reflationary policies, the bond market is not so sure. After initially falling (bond yields rising) after the November 8th election, bond prices have levelled off, and actually rose (yields declined) slightly last month. A more hawkish central bank means interest rates should be going higher, but the Fed’s influence impacts short term rates more than long term rates. Economic growth and inflationary expectations have more influence on long term rates and the decline in long term treasury bond yields means bond traders are less optimistic Trump’s reflationary policies will be successful.
While rising interest rates are negative for government bond returns, they are not necessarily negative for equities, especially given how low rates are presently. The beginning of a Federal Reserve tightening cycle is usually characterized by good equity returns; as a strong economy is typically the reason a central bank starts to increase rates. Only after rates have been raised high enough to start slowing economic growth, do stocks start to correct.
Historically, this has been when 10-year bond yields exceed 5%. Also, when rates become restrictive, the yield curve will typically flatten, or even invert, with longer term yields moving below short term yields. With 10-year bond yields less than 2.5% and the curve at steeper than average spread, there is plenty of room for the Fed to raise rates before the stock market should become concerned.
Europe, on the other hand, could be a nearer term problem. Recent economic numbers, such as investor confidence and manufacturing purchasing manager surveys, have been encouraging, but elections in several European countries this year could put the viability of the Euro-zone in question again.
The headlines are focused on France given the upcoming Presidential elections and, in fact, one of the front runners, Marine Le Pen, has vowed to take France out of the Euro if she gets elected. So far, the markets don’t appear convinced this will happen.
French credit spreads have widened versus their German counter parts, but not dramatically, and real estate prices in Paris have continued to strengthen in line with those of Berlin and London. Le Pen is likely to top the polls after the first round of voting, but is unlikely to be the ultimate winner. Even applying the same margin of error from recent populist victories like Brexit and the U.S. Presidential election isn’t enough to push Le Pen to victory based on current polling numbers. She has been gaining strength, however, so markets will be keeping a close eye on France. A French exit from the Euro-zone would mean the end of the Euro.
Italy is of more concern. Support for the Euro is generally strong in most Euro-zone countries, but it has been falling in Italy with Italians becoming more confident life would be better outside the Euro. Italy isn’t officially due for a general election until next year, but it is possible events could force an election this year. Losing Italy would be a severe blow to the Euro given the size of the Italian economy and its integration in the European economy and banking system.
Overall, there are some positives for the market and a case to be made that the 8-year old equity rally can continue; a lot has to go right, however, and the Trump presidency has gotten off to a rocky start. Higher interest rates and Europe are also on our watch list.
While we are encouraged with the current direction of the economy, we think too much good news is applied to current valuations and that an increase in volatility, including volatility to the downside, would be healthy for the market. We still favor equities over bonds, but wouldn’t be aggressively adding to positions at these levels.
What did you think of February’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.