June In Review: Markets Leave Economists Scratching Their Heads


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 were down 0.8% for the month of June.  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.

Canada and the U.S. experienced a parallel shift higher in yields last month.  The increase was more dramatic in Canada, with yields on 2-year Canada’s increasing 0.41% and 10-year Canada’s +0.35%.  By contrast, yields in the U.S. increased 0.10% across the board.  The more hawkish tone from the Bank of Canada was largely responsible for the move in Canadian yields.  For the month, the NWM Bond Fund was flat, and is up 2.2% year-to-date.  Given the increase in interest rates during the month, this is an outstanding result.

The NWM High Yield Bond Fund returned -1.4% in June.  With a 33% USD exposure, the 4% increase in the Canadian dollar negatively impacted results last month.  The High Yield Bond Index was +0.11% in June, despite a steep increase in interest rates and volatility in the energy markets.  Our managers were mainly flat in the month as well.  Year-to-date the fund has netted a +2.5% return, compared to the Index at +4.9%.  The fund remains defensively positioned with a 4% yield and 2.8-year duration, compared to the High Yield Index that is at 5.7% yield and a 4-year duration.

Global bond returns were weaker last month, with the NWM Global Bond Fund returning -3.0%, with the strong Canadian dollar also negatively impacting returns.  Interest rates were a net-positive contributor to performance as the Templeton Global Bond had a net-negative duration.  Once again, currency was responsible for much of the negative performance in the month.

The 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.  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 are a predictor of future performance, are 4.4% for the NWM Primary Mortgage Fund and 5.4% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund ended the month with cash of $3.0 million, or 1.8%.  The NWM Balanced Mortgage Fund ended the month with $54.8 million in cash or 11.1%.

The NWM Preferred Share Fund returned 3.5% for the month of June while the BMO Laddered Preferred Share Index ETF returned 3.3%.  The month prompted several decisions for many preferred share investors as seven rate resets were extended giving investors the option to stay with a fixed rate or go floating.  Despite 5-year Government of Canada yields moving precipitously higher from 0.94% to 1.39%, almost every investor chose to stay with a fixed rate.  Additionally, National Bank and BMO came to market at 4.45% and 4.4% respectively.  In the next several months we anticipate more and will look to the new issuance market for more defensive positions.

Canadian equities were weak in May with the S&P/TSX -0.8% (total return, including dividends).  The NWM Canadian Equity Income Fund returned +1.5%, with positive contributions from positions in the materials, energy, and financial sectors.  The NWM Canadian Tactical High Income Fund gained 1.0%, despite the decline in the overall market.  The fund still maintains a low net equity exposure (current delta adjusted exposure is 42%).  We added new positions in Cott Corporation and Medical Facilities Corporation in the NWM Canadian Equity Income Fund, while the NWM Canadian Tactical High Income Fund added to its existing position in KP Tissue and we wrote new naked put positions on Saputo and Dollarama.

Foreign equities were weaker last month; with the NWM Global Equity Fund down 3.0% compared to a 3.5% decline in the MSCI All World Index and a 3.3% drop in the S&P 500 (all in Canadian dollar terms).  Like the market, all our external managers had negative returns last month, with Pier 21 Value Invest -5.4%, Pier 21 Carnegie -3.7%, BMO Asia Growth & Income -3.5%, Lazard Global -3.1%, and Edgepoint -0.1%.  Our new internal Europe Australasia & Far East (EAFE) quantitative investments returned -3.6%.

NWM U.S. Equity Income Fund increased 1.1% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.2% versus a 0.6% increase in the S&P 500 (all in U.S. dollar terms).  In the NWM U.S. Equity Income Fund, we initiated a position in Thermo Fisher.  As for the NWM U.S. Tactical High Income Fund, we were called away on our position in GGP Incorporated.  The net equity exposure (delta) in the NWM U.S. Tactical High Income Fund is only 27%.

Real estate was weak in June with the NWM Real Estate Fund down 1.7% versus the iShares REIT Index -0.9%.

The NWM Alternative Strategies Fund was down 2.8% in June (these are estimates and can’t be confirmed until later in the month) with Winton -5.9%, Citadel -5.0%, Millenium -4.6%, and Brevan Howard -4.5%.  We are still in the process of redeeming from the Brevan Howard Fund.  Again, a stronger Canadian dollar provided a headwind for these returns when translated back into Canadian dollars.  Of our other alternative managers, all have achieved positive performance with RP Debt Opportunities +0.5%, Polar North Pole Multi-Strategy +0.9%, and RBC Multi-Strategy Trust +0.3%.

Precious metal stocks were weaker last month with the NWM Precious Metals Fund -1.4%, while gold bullion was down 6.0% in Canadian dollar terms.

June In Review

U.S. equity markets were strong last month, as they have been all year, with the S&P 500 up 9.3% year-to-date after posting a 0.6% advance in June.  It’s been a pretty good year all around, in fact, with only four prominent global exchanges in the red so far this year: Canada, China, Israel, and Russia.

Time to sell?  From a historical perspective, it’s a split decision. Over the past twenty years, there have been only four occasions when indexes started the year in positive territory. Of these, twice the markets went on to see multi-year bull markets. The other two occasions preceded sharp market crashes.

A strong return in the first six months of the year doesn’t mean the rest of the year can’t continue to deliver good performance.  While most Wall Street analysts aren’t forecasting much upside from here, Strategas Research Partners recently pointed out that since 1950, in instances where the market has increased more than 8% in the first half of the year, the market has actually gone on to increase an average 7.2% for the remaining half of the year.

Conditions normally preceding the start of a downturn aren’t present, in our opinion.  Corporate earnings are turning higher, not lower, and market sentiment is not overly bullish.  Case in point, Citigroup strategist Robert Buckland tracks 18 bear market warning signs.  Only two are currently flashing a warning sign.  While we see the potential for a pause or even a temporary pullback; we don’t think it’s time to trade out of stocks quite yet.

Like Buckland, we see some warning signs that warrant watching, but equities still provide better risk adjusted return potential than bonds right now; and for Canada, maybe even a catch-up period.

While it is true, stocks are not cheap, neither are bonds; with returns for 30-year treasuries also up nearly 8% year-to-date.  Based on earnings yield, stocks continue to look more attractive than bonds.

The forward earnings yield for the S&P 500 is currently around 5.6%, 320 basis points more than the yield on 10-year treasuries.  Not only do low-interest rates make stocks look attractive, so does the low current inflation rate.  Since 1950, stock valuations have been highest when CPI has ranged between zero and four percent.

While the bull market may be long in duration, the rise has been fairly steady and orderly without the dramatic run up seen before past market tops.  As we have pointed out in past months, market volatility has been unusually low, which in itself isn’t necessarily good as it shows investors may be overly complacent, but volatility can provide investors with an early warning signal.

Aaron Brown, former head of financial markets at AQR Capital Management, pointed out in a recent Bloomberg article that the VIX has historically traded above 20 before past crises.  At the end of June, the VIX was just over 11.  Also, while soaring technology stocks have garnered a lot of the headlines so far this year, they are not the only sector moving higher.  The market advance has been fairly broad, with multiple sectors starting to break out and only the energy and telecommunications sectors in the red year-to-date.  If the economy continues to gain traction, we would expect the rally to broaden even more with investors shifting their focus away from traditional growth sectors like technology and looking for companies that have lagged during the current slow-growth recovery.

Investors have reacted to the current environment of strong returns and low interest rates by putting cash to work.  According to Citigroup, cash made up only 2.25% of institutional portfolios in June, their lowest level since the current bull market began eight years ago.  For their part, companies have reacted by borrowing more money, pushing leverage ratios back to levels last seen during the financial crisis.  This isn’t a problem given interest rates are at historical lows.  And when we say historical lows, we mean dating back to Roman times.  Why wouldn’t companies take advantage and borrow, even if all they do with the proceeds is buy back their own stock?  And why would portfolio managers leave money in cash earning zero interest?  Only if rates move meaningfully higher do either of these decisions run into problems.  And how likely is that?

Well, according to the U.S. Federal Reserve, a lot more likely than even a few months ago.  The Fed wants to raise interest rates.  They feel they are behind the curve, despite the fact inflation has remained stubbornly low.

Last month the Fed raised overnight interest rates for the second time this year and affirmed their desire to hike rates one more time before year-end.  The Fed would also like to start pairing down their massive $4.5 trillion balance sheet, stuffed with mortgages and treasury bonds acquired during their quantitative easing programs that ended more than three years ago.   The Fed has been reinvesting maturing securities in order to keep their holdings constant but is now contemplating letting some maturing issues simply roll off.  As with their plan to increase overnight rates, the Fed expects to take a measured approach and gradually taper the number of mortgages and treasury bonds they reinvest every month.

The U.S. Federal Reserve is not the only central bank thinking about tightening monetary policy; they are just the farthest along.  The Bank of Canada, the Bank of England, and the European Central Bank (ECB) all signaled an increased appetite for tighter monetary policy last month, though the ECB appeared to backtrack a bit.

Only the Bank of Japan (BOJ) was clear in their desire to keep their current stimulative monetary policy intact for the foreseeable future.  The Bank of Japan is more likely to run out of bonds to buy than the desire to buy them, especially given they presently own upwards of 40% of all outstanding government bonds already.

Given the narrowing output gap in Europe and Japan, it’s hard to see why the U.S. should be the only central bank tightening.  Famous hedge fund manager Ray Dalio, in fact, recently went on record as saying he believed the era of central bank stimulus is coming to a close.  Moves by the ECB and the BOJ will be the key in determining whether Mr. Dalio is right.

For now, however, just the suggestion of tighter monetary policy caused government bond yields to rise everywhere last month, even in Japan.

Canadian and European rates were particularly volatile, with Bank of Canada Governor Stephen Poloz noting excess slack in the Canadian economy is being absorbed “steadily” with growth above potential.  With talk like this, it’s no wonder the market started discounting a nearly 90% chance of a rate increase in July and 50% of another before the end of the year (spoiler alert, the Bank of Canada raised the bank rate 25 basis points to 0.75% on July 12th).  As a result, the Canadian dollar rallied 4% last month.

Economic growth and new job growth have been stronger than expected in Canada.  While the housing market and consumer debt are still a concern, the Canadian economy looks to have weathered the fallout from the drop in oil prices and shock to the Albertan economy fairly well.

As for the Eurozone, ECB President Mario Draghi stated that the ECB’s stimulus program would gradually be withdrawn as the Eurozone economy continues to improve, but even that vague comment was diluted by another ECB official intimating that the market may have over reacted to Draghi’s earlier comments.  With first quarter Eurozone growth topping expectations and coming in higher than U.S. GDP growth, it’s hard to imagine the ECB won’t be looking to start removing monetary stimulus soon; first by gradually tapering monthly asset purchases and then actually raising overnight rates from their current level of -0.375%.  The market is expecting this could happen at the ECB’s December 2018 meeting.  The Euro rallied just under 2% last month; less than the Canadian dollar but then the Euro is up over 8% year-to-date.

Can yields continue to move higher or will the recent the jump be short lived with yields reversing course once again and continuing their long-term secular trend lower?  The key remains inflation, for the U.S. as well as Canada, Europe, the UK, and Japan.

2-year yields are heavily influenced by monetary policy and the central bank, but they have less influence over longer-term yields.  With the yield curve flattening, it is apparent that investors are not convinced interest rates are headed higher; mainly because they don’t see inflation moving higher.

While inflationary expectations, as measured by the difference between nominal yields and the equivalent inflation-protected bond, have moved moderately higher over the past couple of weeks, the 5-year inflationary expectation as measured by the University of Michigan has been declining for the past several years; and no one really knows why.

Demographics, globalization, and technology are all likely all playing a role, as is persistently low wage growth.  Even with a 4.4% unemployment rate, wage growth can’t seem to rise consistently above 2.5% a year.  With the labour participation rate still stuck in the low 60’s (62.8% to be exact), and for men aged 25 to 54, at levels not seen since the great depression, some believe there is still slack in the labour force with a large group of displaced workers that have yet to re-enter the workforce.

Generous benefits have seen over 20% of working-age men opt for Medicaid, while the Census Bureau reports nearly 60% of nonworking men get federal disability benefits.  Perhaps if these benefits weren’t so readily available, more working-age men would find work?

Researchers from Princeton and the University of Chicago recently released a working paper showing evidence that some young men are opting to play video games instead of earning a paycheck.  The authors make the case that the quality of video games has increased dramatically since the year 2000 and is luring many young men away from the workforce and onto their parent’s couches.  The impact is especially pronounced since 2004 and the release of large social games like World of Warcraft.  Parents may want to rethink their choice of Christmas presents in the future.

The Federal Reserve believes there is a strong inverse relationship between unemployment and inflation.  Called the Phillips Curve, it’s one of the reasons the Federal Reserve is willing to continue raising interest rates, even though inflation is AWOL and some economic indicators have turned weaker.  They believe the weakness is temporary and inflation will soon start to accelerate as we move past the current soft patch in economic growth.  If they are wrong, higher rates could snuff out the economic recovery that has slowly been building over the past eight years and throw the economy back into recession.

A steepening yield curve would be a sign they are right as it would indicate investors believe interest rates and inflation will move higher in the future.  A flatter (or even an inverted) yield curve would signal the Fed has made a policy mistake and interest rates and economic growth are likely headed lower. So far, the jury is still out.  Last month, 10-year yields steepened against 2-year yields, while 30-year yields continued to flatten versus 10-year yields.

The fact that the long end of the yield curve has continued to flatten while the Federal Reserve raises rates is viewed as a conundrum; similar to the problem former chairman of the Federal Reserve Alan Greenspan observed in 2004 when he was raising interest rates, only to see bond yields fall.

Here are a few more market conundrums we see presently, and some possible explanations why they are happening:

Even though the Federal Reserve is increasing rates, the U.S. dollar is falling against most major currencies despite the fact their respective central banks haven’t actually started to increase rates themselves yet. We would expect the U.S. dollar to be moving higher as interest rates rise and higher yields make U.S. products more attractive.

The market is likely anticipating that global growth will continue in a linear fashion and other developed economies will follow the path of the U.S. economy; gradually recovering and eventually raising interest rates.

In addition, U.S. growth has recently disappointed at the margin.  We view this as a short-term phenomenon.  If the U.S. economy continues to stall, we don’t see prospects for the global economy continuing to improve.  Do you really think the Eurozone will become the world’s engine of growth?

The market isn’t adjusting prices in consideration of the potential economic growth resulting from any of President Trump’s policies.  To that end, health care reform may be dead, but we haven’t given up on tax reform quite yet, and deregulation is already in the works.

Also, a weaker U.S. dollar is positive for future U.S economic growth.  It’s very convenient that the dollar has come under pressure given President Trump’s focus on trade and his belief America has gotten the short end of the stick from its trading partners.  If you were a foreign trade official about to start negotiations with the U.S., would you rather see you currency strengthen or weaken?

Equally perplexing is the fact that stocks have been moving in the same direction as yields, meaning they are positively correlated.  Typically, one would expect higher interest rates to weigh on stock valuations as the present value of discounted earnings is lower if the discount rate is higher.  Also, the market typically anticipates that higher interest rates will eventually slow economic growth, thus lowering corporate earnings in the future.

Deutsche Bank economist Torsten Slok believes the notion that stocks and yields should be negatively correlated is old school thinking and hasn’t been true for nearly two decades.  In the 1970’s and 1980’s, inflation was much higher and a move up in rates was likely due to higher inflation.  Higher inflation was considered bad for the economy, and thus bad for stocks.  Today, however, inflation is low and relatively stable.  Higher interest rates are more likely to be associated with stronger economic growth, which is good for stocks.  As we mentioned above, it’s only when inflation has risen above 4% has higher inflation negatively impacted valuations historically.

Another conundrum is the recent price action of gold, which has turned lower, despite the fact the U.S. dollar has weakened.  Normally a weak dollar is good for gold prices, as are geopolitical crises like a potential conflict on the Korean peninsula.  We have always looked at real interest rates as the true driver behind gold prices.

With bond yields headed higher last month and inflation still nowhere to be seen, real bond yields are likely to continue to rise.  This has always been the risk for gold.  If real interest rates are positive, we would rather hold U.S. Treasuries as our safe haven insurance policy as gold doesn’t pay any interest.

Given economic growth is still slow and consumers and governments have too much debt, we don’t see real interest rates moving much higher.  We think central banks see negative interest rates as part of the solution when it comes to deleveraging.  For interest rates to move meaningfully higher, inflation will need to do most of the heavy lifting.  We would still be buyers of gold.

Finally, what about the Canadian dollar and oil?  WTI Oil moved down nearly 6% last month, which in itself is a conundrum given commodities tend to do better when the U.S. dollar is weak.

Historically, there is a strong relationship between the Canadian dollar and oil, but last month they moved in opposite directions.  Painfully, this meant WTI Oil priced in Canadian dollars fell nearly 10%.  This is tough on the Canadian energy sector and one of the reasons Canadian stocks underperformed last month.  We believe the issue for oil is a supply story, not a demand story.  Oil inventories are too high given strong production, not only in the U.S. but Libya and Nigeria as well.  This will be a self-correcting problem as lower oil prices will lead to lower investment and thus lower future supply.  In addition, higher interest rates could reduce U.S. shale production, which has benefited from very favorable credit and liquidity conditions.  Oil needs to move higher and Canadian energy companies will benefit when it does.

Higher interest rates should also help the Canadian financial sector, especially banks and insurance companies.  If energy and financials start acting better, well, that’s nearly 60% of the entire Canadian stock market.  The Canadian dollar was oversold and due for a correction higher, but a move above 80 cents will be tough to achieve.

The Summary

The threat of higher interest rates will keep markets on edge over the coming months.  Volatility might increase and markets could pullback in the short term, but we think the longer term bull market will remain intact.  Central bank tightening will be slow and measured.  Interest rates may drift higher, but only if the economy continues to strengthen.

The shape of the yield curve will provide a good measuring stick.  If the yield curve gets too steep, it means central banks are behind the curve and need to tighten monetary policy more.  If the yield curve flattens, it means economic growth is stalling and inflation is dropping.

As for currencies, we still believe the U.S. (dollar and the economy) is the world’s least dirty shirt.  In a world where the U.S. is the only central bank raising interest rates, the U.S. dollar would move unsustainably higher.  Last month we were reminded why this can’t happen.  Either economic growth in other developed economies improves and they too start to increase interest rates, or a strong U.S. dollar will eventually slow U.S. economic growth relative to the rest of the world; last month we saw a bit of both.

 

What did you think of June’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. Please speak to your NWM advisor for advice based on your unique circumstances. NWM 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 only available for sale to tax residents of Canada who are accredited investors. Please read the agreements and/or subscription documents for additional details and important disclosure information, including terms of redemption and limited liquidity.