March In Review: Looming Trade Wars Capture Investors’ Attention Last Month


By Rob Edel, CFA

Highlights This Month

Read the monthly commentary in PDF format.

The Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 0.3% in the month of March. 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.

Both Canadian and U.S. yield curves flattened last month, with the Canadian 10-year yields falling nearly 15 basis points to 2.09% while 10-year U.S. Treasury yields dropped 12 basis points to 2.74%. Short-term yields (2-year government bonds) in both Canada and the U.S. were virtually unchanged. The impact on returns for the NWM Bond Fund was muted, with the fund flat for the second month in a row in March.

NWM High Yield Bond Fund gained 0.1% last month, outperforming the Bank of America Merrill Lynch U.S. High Yield Index which was -0.6%. It has been the high yield market’s most volatile quarter since late 2015/early 2016, with the index returning -0.9% in Q1. By contrast, the NWM High Yield Bond Fund performed steadily and gained 1.3% in the quarter, so far affirming our thesis that we are positioned defensively and differently than high yield beta. This fund’s net yield remains a fair bit lower than the index at 4.3% versus 6.3%, explained by defensive positioning, particularly with the lower yielding long/short components of the fund. But with greater volatility and increasing yields in the market, we are seeing more opportunities to capture higher yields in the fund.

The NWM Global Bond Fund was +1.1% in March, which was aided by a 0.4% decline in the Canadian dollar.

The NWM 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 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 4.5% for the NWM Primary Mortgage Fund and 5.5% for the NWM Balanced Mortgage Fund. NWM Primary Mortgage Fund ended the month with negative cash of $2.2 million, or 1.4% (we utilized our short-term credit lines). NWM Balanced Mortgage Fund ended the month with $43.8 million in cash or 9.1%.

The NWM Preferred Share Fund returned -1.3% for the month while the BMO Laddered Preferred Share Index ETF returned -1.4%. 5-year Government of Canada bond yields moving lower and widening credit spreads hurt returns overall. Floaters were down 2.4% for the month contributing to weakness while positions in Artis REIT and EFN were the largest detractors from returns. Overall, we continue to like Artis REIT although there are concerns over its exposure to the Alberta market and high payout ratio as its AFFO payout ratio is over 100%. However, new development projects should reduce its payout ratio and the company needs to completely cut all dividends for common equity shareholders before it can cut dividends for preferred shareholders. Given Artis’ healthy balance sheet and reduction in leverage over time, we will look to increase our position as the opportunity presents itself.

Canadian equities were slightly weaker in March with the S&P/TSX -0.2%. The NWM Canadian Equity Income Fund returned -0.9% in March. We added Great Canadian Gaming and Teck Resources. We sold our positions in Winpak, Power Corp, and Uni-Select. Top contributors to performance were Methanex, Sleep Country, and Dollarama. Largest detractors to performance were Westshore, Canadian Western Bank, and Alimentation Couche-Tard. Our financial overweight continues to be a drag on performance. Although the sector should be a beneficiary as bond yields move higher, we have not seen an uplift in the stock prices. Also, EFN has been plagued by poor performance, bank covenant, and leverage fears and has been a large detractor to performance so far this year.

The NWM Canadian Tactical High Income Fund returned -0.4% in March which slightly trailed the S&P/TSX’s -0.2% return. The best performing sectors last month were real estate & utilities which this fund had no exposure. The market volatility dropped approximately 12% during the month but specific names we were writing options on experienced increases in volatility. We are still taking a defensive view in the NWM Canadian Tactical High Income Fund aiming to receive mid-to-high single digit annualized option premiums while providing close to 10% downside protection. We believe that market will be volatile over the next few months; hence, we will be selective in writing put options on high-quality companies with low financial leverage.

The NWM Global Equity Fund returned -0.3% vs -1.5% for the MSCI ACWI (all in CAD$). This fund outperformed the benchmark mainly due to being underweight in the U.S. & China and being overweight in Japan & U.K.. On a sector basis, the NWM Global Equity Fund was underweight in the worst performing sectors, financials, materials and info tech. The best performing fund was our quality small-cap manager (Lazard), which returned +0.8%, and the worst performing fund was Carnegie (-2.1%) due to their heavy exposure in financials & info tech (Facebook, Alphabet, Wells Fargo and Citigroup were all down more than the market last month). Rounding out the list was ValueInvest was +0.7%, Edgepoint +0.6%, and BMO Asian Growth & Income +0.4%. Our new internal Europe Australasia & Far East (EAFE) quantitative investments were -1.4% vs -0.1% MSCI EAFE with idiosyncratic risks detracting from performance while style bets contributed.

The NWM U.S. Equity Income Fund was down 2.3% versus -2.5% for the S&P500. Gains in Nextera Energy, Estee Lauder, and not owning Facebook more than offset underperformance from DowDupont, Citigroup and not owning Intel. Our overweight in Banks hurt but this was more than offset by positive relative performance from not owning Biotechnology and our positioning in personal products such as Estee Lauder.  All of the positive relative performance came during the last two weeks of March when the equity markets were soft. In terms of trades, we added two names to the portfolio:  Carnival Corp, the world’s largest cruise operator with strong business fundamentals, and Xylem, a manufacturer, and service provider for water and wastewater applications also benefiting from strong fundamentals. We sold Ingersoll-Rand, an industrial company specializing in heaters and air conditioners.

The NWM U.S. Tactical High Income Fund’s performance was -0.6% during the month versus -2.5% for the S&P 500. This fund’s outperformance was due to low equity equivalent exposure (approximately 35% at the beginning of the month). Real estate, utilities, and energy were the best performing sectors, helped by declining interest rates as well as higher oil price. No new names were added during the month but we did add more of our existing names when volatility moved higher. The NWM U.S. Tactical High Income Fund continues to focus on downside mitigation and has been writing put options on low financially levered names.

In real estate, NWM Real Estate Fund was up 0.4% in March versus a 2.1% increase in the iShares REIT Index.  We report our SPIRE hard asset real estate Limited Partnerships in this report with a one month lag. As of March 31st, February performance for SPIRE Real Estate LP was +0.9%, SPIRE U.S. LP +0.8% (in U.S. dollars), and SPIRE Value Add LP +2.0%.

The NWM Alternative Strategy Fund was up +0.8 in March (these are estimates and can’t be confirmed until later in the month) with Winton +0.5% and Millenium +1.5%. Of our other alternative managers, RP Debt Opportunities was -0.3%, Polar North Pole Multi-Strategy +0.2%, RBC Multi-Strategy Trust +0.1%, Apollo Offshore Credit Strategies Fund Ltd +0.4%, and Verition International Multi-Strategy Fund Ltd. +1.8%.

Precious metals stocks were stronger last month with the NWM Precious Metals Fund +5.3% while gold bullion gained 0.9% in Canadian dollar terms. 

March In Review

After avoiding even a single month in the red last year, U.S. stocks fell for the second month in a row in March; with the S&P 500 falling 2.5% or 1.9% in Canadian dollar terms. Predictably, higher volatility accompanied the weaker returns. In 2017, the S&P 500 declined over 1% in a single trading session on only four occasions and never posted losses exceeding 2%. In March alone, U.S. stocks fell more than 1% five times, with three of these trading sessions seeing losses in excess of 2%. In addition, April has gotten off to a rough start with the S&P 500 breaking below its 200-day moving average for the first time since June 2016. As for Canadian stocks, the S&P/TSX also ended the month in the red but only just barely, declining 0.2%.

According to the American Association of Individual Investors weekly sentiment survey, market participants have turned decidedly bearish after reaching their most bullish level since late 2010 only a couple months ago. What has caused such investors angst? A trifecta of fears, namely a tightening central bank, a trade war between the U.S. and China, and weakening technology stocks. All three were listed as potential “tail risks,” unlikely events with large negative implications by fund managers in a recent Bank of America Merrill Lynch fund manager survey. Trade war and inflation (which would drive central bank tightening) actually topped the list while the tech bubble came in sixth. We will tackle all three below.

As expected, the Federal Reserve increased short-term interest rates last month, raising the Fed Funds Rate 25 basis point to a range of 1.50-1.75%. While the median year-end forecast from the various Fed members continued to indicate only two more increases this year, there was a slight shift towards the possibility of three more increases before the end of the year. For 2019 and 2020, median and mean forecasts increased by at least 25 basis points each.

Fears of higher inflation resulting in tighter monetary policy were largely responsible for the pullback in the market in February, and as a result, investors have become very sensitive to any signs the Fed is becoming more hawkish. Higher inflation could give the Fed the green light to raise rates more aggressively but their timing has to be perfect. Tighten too quickly and risk derailing the economic recovery that is only now starting to gain steam. Tighten too slowly and risk letting inflation get out of control, which would require even higher interest rates to reign in. For its part, the market doesn’t believe the Fed will tighten as quickly and as much as the Fed is forecasting, either because the Fed has tended to overshoot in their recent rate forecasts or because they don’t believe the economy and inflation will be as strong as the Fed believes.

As can be seen in the charts below, inflation has firmed and news reporting on inflation has spiked higher. The increase has been relatively mild, however, and inflation is considered to be a lagging indicator. Inflationary expectations, which are more forward-looking, have actually softened.

This is important because at the margin, the economy itself looks to have cooled.  First quarter U.S. GDP, as estimated by the Atlanta Fed’s GDP Now Indicator, is presently under 2% and the CITI G10 Economic Surprise Index looks to have rolled over. To be fair, most of the decline in the Citi Economic Surprise Index can be attributed to Europe, but U.S. purchasing manager indexes have retreated off their highs and forecasted odds of a recession have increased.

Capital markets appeared to confirm the slowdown with 10-year U.S. Treasury yields retreating in March while shorter-dated 2-year treasury yields were relatively unchanged. Higher credit spreads and weaker base metal prices also pointed to weaker growth, as did a relative bounce in the price of gold.

We view gold as a store of value and a hedge against the declining purchasing power of fiat currencies but some investors also view it as a safe haven asset and buy it in times of uncertainty. With Donald Trump as President there is no shortage of uncertainty and last month the threat of a trade war with China dominated the headlines.

In late March, the U.S. announced tariffs on approximately $50 billion of Chinese imports. China quickly countered with tariffs on a similar amount of U.S. goods imported to China. The U.S. claimed their action was in response to unfair Chinese trade practices which pressure U.S. companies to surrender their intellectual property to Chinese joint venture partners in exchange for access to Chinese markets.

China’s centralized government has targeted 10 strategic emerging industries in which they aim to become global leaders and appear more than willing to break WTO rules in order to give their companies an unfair advantage. In order to emphasize this point, the 1,300 products targeted by U.S. tariffs targeted industries where U.S. companies have been pressured to transfer their intellectual property. China’s immediate response was to counter with tariffs meant to inflict maximum political damage, concentrating on products sourced from the home States of House of Representatives Speaker Paul Ryan (cranberries from Wisconsin) and Senate Majority Leader Mitch McConnell (whiskey from Kentucky). Soybeans were the big ticket item, grown in key Midwestern states that supported Trump in the 2016 Presidential election. Not to be outdone, Trump upped the ante even more, countering with the potential of tariffs on an additional $100 billion of imports.

Investors were quick to see where this was heading and promptly sold equities and bought bonds, driving down the price of the former and up the price of the latter. Both sides claim they don’t want a trade war and U.S. officials are quick to emphasize that tariffs are a negotiating tool meant to bring China to the table.

This is also not the first time China has been accused of breaking the rules and not just by U.S. companies. As Thomas Freidman wrote in a recent New York Times article, “some things are true even if Trump believes them.”

Even the Washington Post ran an article agreeing with Trump. The Washington Post! They don’t agree with Trump on anything. U.S. negotiators are frustrated by China’s lack of compliance and the inability of the WTO to enforce the rules. In addition, many foreign companies are reluctant to make claims against China for fear of being locked out of the world’s second-largest economy.

No one wins a trade war and global economic growth will be the loser if a trade war breaks out but it is interesting to watch the reaction by some in the media, as well by some U.S. politicians, to the position the U.S. is taking. Yes, Trump’s actions are aggressive and not without risk but given the U.S. runs a $375 billion trade deficit with China, doesn’t it stand to reason the U.S. might have the upper hand? If China counters Trump’s threat of tariffs on an additional $100 billion of imports, they would essentially be putting tariffs on more than 100% of all U.S. good exported to China given that the total U.S. exports to China were only about $130 billion last year.

The U.S. economy actually has very little exposure to China, especially compared to that of Australia, Japan and Germany. Sure, China could threaten to sell their hoard of U.S. Treasury bonds, driving U.S. interest rates higher, and financial markets into a panic, but this would also push the U.S. dollar lower and the Chinese Yuan higher, making Chinese exports less competitive.

Another strategy might be to devalue the Yuan but concerns over capital outflows might prevent this from becoming a legitimate alternative. The one advantage China has is it doesn’t need public approval or support, nor does it care about the short-term hardships a trade would put on its people. China is all about the long-term. U.S. leaders care very deeply and Donald Trump probably most of all. This is China’s game plan and the reason why their tariffs were targeted to inflict optimal political damage. They are willing to endure the pain with the belief America’s pain threshold is much lower.

We believe a deal will be struck and the current threats are negotiating tactics being used by both sides. In the meantime, the uncertainty and headline risks will lead to higher market volatility.

The market hates uncertainty and nowhere is uncertainty more prevalent than in Washington. With the economy finally on the mend and the Republicans controlling both Congress and the White House, one might expect uncertainty around economic policy to decline, but it’s not. According to an index created by academics from several prominent U.S. universities which tracks economic articles published in major newspapers for the frequency of the words “uncertain” and “uncertainty,” uncertainty is peaking rather than receding.

Tariffs and the potential fallout of a trade war is one source of uncertainty but the technology sector became another victim last month, especially the high flying FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google). Facebook played a prominent role in the headlines given the Cambridge Analytica data breach scandal and growing scrutiny over how Facebook and other large internet platforms protect and use their vast and growing collection of personal user data, but it was Amazon that appeared to be President Trump’s favorite target.

Trump believes Amazon is taking advantage of the U.S. Postal Service in getting below market rates for delivering packages. Trump also hears from his wealthy contacts the negative impact Amazon has had on retailers and shopping centers. Potential anti-trust action would be challenging, however, given principles guiding American anti-trust enforcement has historically centered on consumer welfare rather than anti-competitive issues. Given the downward pressure on prices Amazon has created, it’s tough to argue the consumer has been harmed by their actions. Some suspect Trump’s real target is Amazon CEO Jeff Bezos rather than Amazon itself. Bezos owns the Washington Post, a vocal and persistent critic of all things Trump.

Despite Trump’s negative tweets, Amazon wasn’t the hardest hit tech stock last month, nor was Facebook for that matter. The selloff was relatively broad and extended beyond companies impacted by the problems faced by Facebook and Amazon. Tesla and Netflix, for example, both fell but have business models very different from advertising-focused giants like Facebook and Google’s parent, Alphabet, and both have nowhere near the market power as Amazon.

One explanation for the correction is the extreme price momentum the technology sector, in general, has benefited from and the dominance of big tech stocks in investor portfolios. Tech accounts for over 25% of the S&P 500 and just five stocks: Apple, Microsoft, Amazon, Alphabet, and Facebook alone total nearly 15%. Technology stocks have appreciated at an annualized rate of 18.5% since 2015 versus just over 10% for the market as a whole. Comparisons to the dot-com bust serve as a potential warning to investors given technology made up 29% of the S&P 500 at its peak in 1999.

There are, however, distinct differences between the dot-com tech stocks and today’s technology leaders. While technology comprised 29% of the S&P 500 in 1999, it made up just 13% of its earnings with valuations soaring to unsustainable levels. Despite the recent outperformance, valuations for today’s technology leaders are much more in line, with the sector contributing 23% of the S&P 500’s earnings. Given technology stocks are expected to grow earnings 22% in the first quarter, versus 17% for the S&P 500 in total, tech stocks could actually be viewed as cheap or at least reasonably priced.

For their part, analysts are still fans with most maintaining their buy rating on Facebook, Amazon, and Alphabet. More regulation around privacy is possible but bear in mind the Trump administration got elected on a platform of less, not more, regulation.

The big U.S. tech companies are global winners, and with a future economic war with China looming, the Republicans will likely think twice before putting their champions at a competitive disadvantage. China doesn’t care about privacy issues, in fact, the more data they can collect on their citizens the better. Rather than viewing the correction in the technology sector as related to concerns specifically about the sector, some believe the correction could simply be a result of the general market correction that began in late-January and falling tech stocks are an example of the strongest sector falling last.

We don’t dismiss the potential that increased regulation will negatively impact the business models for large and dominant technology companies. We are also wary of the potential for a trade war abruptly bringing the current bull market to a close and driving the global economy into recession. We balance these risks, however, against the positive environment we see in the economy and the potential for earnings growth to power stock prices higher, even with moderately higher interest rates. The recent correction has helped bring valuations back to more reasonable levels after a January melt up threatened to move the market to unsustainable levels. Meanwhile, we continue to look for signs the business cycle is ending and a bear market is emerging, but we don’t see it quite yet.

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 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 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. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.