By Rob Edel, CFA
Highlights This Month
- Economists show signs of optimism.
- Trump’s first task: corporate tax reform.
- Republicans aim to ease regulations hindering business.
- Trump takes no prisoners to get America’s “great again” economy.
- The Donald plays offence against trade and globalization.
- The problem with infrastructure spending.
- Investors to blame for inflated valuations of Trump-favoured businesses.
- Watch Europe as elections approach.
- How is China coping as we close 2016?
- This is how Trump is boosting corporate America’s confidence.
- Warning: practice caution when jumping onto The Donald’s economic bandwagon.
The NWM Portfolio
Returns for the NWM Core Portfolio Fund increased 1.0% for the month of November. NWM Core Portfolio 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.
Short term interest and the steepness of the yield curve in both Canada and the U.S. continued to increase in November. Fortunately, our actively managed strategies were able to offset much of the decline from higher interest rates such that the NWM Bond Fund was flat last month. ArrowCapital’s East Coast Investment Grade Income Fund continues to perform strongly in this environment and was up 0.9% in November and +13.6% year to date. Marret Investment Grade Hedged Strategies Fund has also performed well, up 0.1% last month, but +7.1% for the year.
Credit strategies also performed well last month with higher coupon debt further offsetting rising interest rates in most cases. The NWM High Yield Bond Fund was +0.3% in November.
A strong U.S. dollar, especially against emerging market currencies, was mainly responsible for the weak global bond returns last month, with the NWM Global Bond Fund down 2.4%.
NWM mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage Fund and NWM Balanced Mortgage Fund returning +0.3 and +0.4% respectively in November. 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 4.2% for NWM Primary Mortgage Fund and 5.4% for NWM Balanced Mortgage Fund. The Primary Mortgage Fund ended the month with cash of $21.0 million, or 13.4%. The Balanced Martgage Fund ended the month with $47.9 million in cash, or 10.6%.
NWM Preferred Share Fund was down for the month of November returning -0.3%, while the BMO Laddered Preferred Share Index ETF returned +0.2%. Returns for the market were driven by the bifurcation between low and high reset spreads. Positive low-reset spread performance was driven mainly by the 5-year Government of Canada Bond yields moving violently from 0.69% to 1.01%, while higher reset spread issues were sold off and were used as a source of liquidity to fund the $3.5 billion of new issuance that came to market during the month.
Although we have been positioned for rising rates, market headwinds were caused by new preferred share issues that represented an increase of over 6% of the size of the whole preferred share universe. We anticipate increased demand and higher interest rates will be the dominating factors driving returns for the foreseeable future.
Canadian equities were positive in November, with the S&P/TSX +2.2% (total return, including dividends), while NWM Canadian Equity Income Fund and NWM Canadian Tactical High Income Fund were up 4.0% and 1.8% respectively. Both portfolios benefited from not owning any gold stocks last month, while being overweight in financials and industrials also contributed to NWM Equity Income Fund’s relatively strong performance last month. Given the NWM Canadian Tactical High Income Fund’s defensive positioning, and an average portfolio delta of under 40%, returns were strong from a relative perspective.
In the NWM Canadian Tactical High Income Fund, we trimmed our positions in Constellation Software, Ag Growth, and PrarieSky. We added to existing positions in Suncor, Maple Leafs Foods, and Brookfield Asset Management, as well as initiated a new position in Uni-Select. In the NWM Canadian Tactical High Income Fund, we added to our existing positon in Morneau Shepell and wrote additional put options on Maple Leaf Foods.
Foreign equities were stronger in November with NWM Global Equity Fund up 0.5% compared to a 1.5% increase in the MSCI All World Index and a 3.7% rise in the S&P 500 (all in Canadian dollar terms).
The results from our external managers were mixed last month. Edgepoint and Lazard Global were positive, up 7.1% and 3.5% respectively, while Pier 21 Carnegie, Pier 21 Value Invest and BMO Asia Growth & Income were negative, down 2.1%, 2.7%, and 2.8% respectively. The NWM U.S. Equity Income Fund increased 4.4% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.9% versus a 3.7% increase in the S&P 500 (all in U.S. dollar terms).
In the NWM U.S. Equity Income Fund, we sold our positions in Charter Communications and McKesson, and added to existing positions in Medtronic, Stryker, Alphabet (Google), and Adobe. As for the NWM U.S. Tactical High Income Fund, we added a new short put positions in Sherwin Williams and added to our short put position in Becton Dickinson.
Real estate increased in November with the NWM Real Estate Fund up 0.4% versus the iShare REIT Index down 0.8%.
NWM Alternative Strategies Fund was up 0.3% in November (these are estimates and can’t be confirmed until later in the month). Of our Altegris feeder funds, Brevan Howard and Millenium were up +3.5% and 0.3% respectively, while Winton and Citadel were both down 1.1%. With the exception of MAM Global Absolute Return Private Pool, which was down 0.2%, all our other alternative managers were up: RP Debt Opportunities +0.4%, Polar North Pole Multi-Strategy +0.9%, RBC Multi-Strategy Trust +1.9%.
Precious metals were weak again in November with the NWM Precious Metals Fund -16.2% and gold bullion was down 8.6%, in Canadian dollar terms.
November In Review
Donald Trump campaigned on a promise to “Make America Great Again” according the market, it looks like he has succeeded and he hasn’t even taken office yet!
The S&P 500 rallied 3.7% in November and the Dow was up nearly 6%, with the bulk of the gains occurring post Trump’s unexpected victory. Canadian stocks managed a decent 2.2% return, while the MSCI World Index was 1.5% higher. Bonds didn’t fare as well, however, with U.S. 10-year treasury yields backing up nearly 60 basis points to 2.4% in November, up over 100 basis points since July. According to Bank of America Merrill Lynch, most bond indexes suffered their worse price declines since 2004 last month and investors pulled more than $30 billion out of bond funds and ETF’s, the largest net outflow since 2013.
It didn’t matter if returns were measured in Canadian or U.S. dollars last month as the loonie was basically unchanged in November, though it depreciated just under 2% against the U.S. dollar since the November 8th election. Other currencies were hit even harder, however, as the U.S. dollar rallied nearly 4% after the election against a basket of major world currencies (the U.S. Dollar Index – DXY), hitting 13-year highs during the month. The dollar was particularly strong against emerging market currencies such as the Mexican Peso, which declined 11% against the greenback. In combination with higher interest rates, a stronger U.S. dollar serves to tighten financial conditions in America, which in turn could threaten the economic recovery.
Of course, that is only the case if the economy was just ok. A “great” economy should have a strong currency, as well as rising interest rates and increasing stock prices. And that’s what we saw last month. Check, check, and check. Mission accomplished President-Elect Trump, well done!
A tad premature you say? Perhaps, but growth continues to track in the right direction and the Donald will inherit a far stronger economy, when he is inaugurated on the January 20th, than President Obama did eight years ago.
Optimistically, there are some things in Trump’s platform we think could help drive growth even higher, like tax reform and regulatory relief. On the other hand, we are less enthusiastic about infrastructure spending, and we are downright scared to death over his attitude towards trade and globalization. Some of Trump’s policies likely won’t make it off the drawing board, and it is debatable how much impact any government program will have in the post-recession slow-growth world, where population and productivity growth have slowed.
Oh, and don’t expect much help from the global economy. The U.S. economy is the brightest of the lot. Bond yields may have risen in anticipation of stronger economic growth, but if recent history is any guide, the rally in rates (decline in price) could be short lived. Is it truly different this time? Have we really reached an inflection point in the post-recession recovery, or is the recent move in the capital markets another false start?
So far, most economists are giving Trump the benefit of the doubt. While it is true, bond yields and inflation rates were beginning to meander higher before the election, it was only after the Republican’s swept all three branches of government did economists start moving their targets for GDP growth and inflation higher.
Investors are waging Trump and his Republican colleagues will reflate the U.S. economy. If this is indeed the case, the recent increase in interest rates will have been warranted. If growth remains elusive, however, the markets pre-emptive tightening will actually serve to slow economic growth even more. A simulation conducted by Macroeconomic Advisors estimates a further 50 basis point increase in 10-year yields could result in first quarter 2017 GDP growth falling to only 0.9% if the current trend of economic growth is maintained. A full percentage point increase would see economic growth decline such that the Fed would be obligated to cut interest rates back down to zero again.
Of course most economists, and central bankers for that matter, believe monetary policy has done more than its share of the heavy lifting when it comes to stimulating the economy; fiscal policy needs to pick up the slack. President-elect Trump and the Republicans agree that corporate tax reform will be at the top of their agenda come January 20th. At 35%, America has the highest corporate tax rate in the industrial world, as many countries have been consistently lowering rates in order to attract capital and jobs. According to Goldman Sachs, Trump’s corporate tax cuts could help boost U.S. corporate earning up to 4% next year. In addition, Trump has advocated a one-time 10% repatriation tax to lure back the estimated $2.5 trillion in cash U.S. corporations have stashed overseas.
Of course, lowing taxes is not as easy as it sounds. House Republicans have a different plan than the Donald, but both are likely to result in higher budget deficits, especially in the short term. Headline corporate tax rates may look high, but loopholes and deductions mean the average rate U.S. companies actually pay is below the OECD average.
It is likely the Republican’s final plan will include the elimination of loop holes and deductions such that tax cuts will be revenue neutral, or close to it. This will help get more Republican congressmen on board, but may impact earnings less than the market is anticipating. In the end, tax reform could be more about restructuring how companies pay tax rather than large simulative tax cuts. After all, the U.S. is far from over taxed when compared to other countries. Tax rates are deceiving because the U.S. relies more on income tax to generate revenue while other countries favour consumption taxes.
Perhaps an even easier target than corporate tax reform, for Trump, is regulatory relief. He has promised to make it easier for businesses to operate and has pledged to eliminate two regulations for every new one passed. He has also stated he would like to shut down the Education Department and parts of the Environmental Protection Agency. Trump and the Republican Congress are keen to advance regulatory policies more advantageous to U.S companies, with the financial, service, energy, health care, and manufacturing sectors all prime targets for relief.
Vermeer Corp. makes construction and farming machinery. In a recent WSJ article, CEO, Jason Andringa, was quoted saying “the continued onslaught of regulation over the last eight years – that probably has been, pretty much, our number 1 overall concern as manufacturers”. President Obama was particularly fond of creating economically sensitive regulations and many believe there is a direct correlation between deregulation and income inequality. Regardless, Trump will squash as many as he can, and economic growth should be the better for it – the environment and income equality, perhaps not so much.
Republicans believe the economy will grow faster if government is less intrusive. Interestingly, Trump’s recent move to personally intervene in U.S. heating and air conditioning manufacturer Carrier’s plan to relocate 800 jobs from Indiana to Mexico, could be perceived as doing just the opposite.
During the election campaign, Trump talked about imposing a 35% tariff on products sold by companies that have moved production abroad. Not only would this result in higher prices for U.S. consumers, but it would reduce the competitiveness of U.S. companies and prevent them from utilizing global supply chains they have developed over the years.
For sophisticated electronics, for example, Asia has large pools of migrant workers, which enable manufacturers to quickly scale production, and a sprawling supply chain of component manufacturers. According to Jason Dedrick, a professor at Syracuse University, the retail cost of an iPhone could increase about 14% if it were made in America.
As for the auto industry, it’s not uncommon for the thousands of parts, used to manufacture a vehicle, to come from multiple producers in different countries and for those parts to travel across borders multiple times during the production process. A car might be assembled in America, but it is unlikely all the parts are. Untangling this supply web would add costs and reduce efficiency and productivity. Trump appears to view the trade as a zero sum game; other countries need to lose in order for America to win.
The U.S. certainly has lost manufacturing jobs over the past three decades, but this is a global trend and largely a result of automation and productivity growth. Deloitte believes this trend actually favours America and believes the U.S. will become the most competitive manufacturing nation by 2020, but it likely won’t result in a lot of new jobs. Highly skilled and higher paying, yes, but days of large assembly lines manned by humans are likely behind us. Trump’s anti-trade rhetoric won’t bring back jobs, or corporate profits.
On the one hand, Trump’s policies focus on making American industry stronger and more competitive in order to attract capital and jobs. Corporate tax reform and regulatory relief fall into this category. On the other hand, the Donald appears to want to take a more protectionist approach to trade, viewing globalization as a threat to the American middle class.
Trump’s policies on illegal immigrants, especially from Mexico, are another example of this. The economic reality, however, is illegal immigrants are not all “bad hombres,” but rather valuable contributors to the U.S. economy. City University of New York estimates that the seven million plus illegal workers in the U.S., 55% of whom are estimated to be from Mexico, represent about 3% of private-sector GDP.
If anything, small businesses would like more, rather than less, Mexican workers as they form the backbone of industries like hospitality, agriculture, and construction, all of which are scrambling to find workers in today’s 4.6% unemployment world. The Donald might want to build a wall to keep Mexicans out, but fewer and fewer are actually crossing the border, and some industries are suffering as a result. According to the Bureau of Labour Statistics, the combined restaurant and accommodations sector had 700,000 vacant positions in May, the highest since 2001.
Another Trump policy we are not sure about is infrastructure spending. It sounds good in theory, drive economic growth higher by spending more on much needed infrastructure projects. The American Society of Civil Engineers estimates just repairing America’s existing infrastructure over the next decade would cost more than $3 trillion.
Government infrastructure spending is also deemed to be productive given it can provide a more tangible return on investment. A new highway, for example, can increase productivity by decreasing transportation costs. Of course, not all projects are created equal, and politics often plays a greater role than common sense when the government is footing the bill.
Another problem is how to pay for it. Adding a trillion dollars of infrastructure spending to the growing U.S. debt load could be a non-starter for some Republicans. Trump favours using tax credits and private-public partnerships, but this means the projects would need to generate revenue, like tolls. Some infrastructure doesn’t lend itself for tolls, or if there are tolls, there is no guarantee people will use them. According to the Congressional Budget Office, of the eight recent highway projects that relied on private funding and have been open for more than five years, four have either declared bankruptcy or required a public bailout.
Despite historically mixed returns compared to stocks, private infrastructure funds have been aggressively raising money, but have become fairly selective in which projects to support. As such, there not so much a shortage of capital as a shortage of investible projects in the private sector. We get the fact monetary policy is done, but we’re not convinced fiscal policy is the answer. If it were, Japan, with its fancy maglev trains, elevated highways and suspension bridges would not be in the deflationary funk it is. One only has to remember the Simpson’s “Monorail” episode to be wary of slick salesmen selling large fancy infrastructure projects.
While we might be skeptical over some of Trump’s policies, the markets appear less so. Not only are equities generally moving higher, but investors are bidding up the prices of specific companies and sectors that would prosper if Trump is successful. Due to the prospect of the U.S. initiating the construction of large infrastructure projects, copper, steel, and construction materials in general have been rising.
The financial and energy sectors have rallied on the prospect of deregulation, as have smaller companies, which would also benefit from corporate tax reform and gradually more protectionist environment. Most small companies generate the bulk of their revenue domestically, and they tend to have high tax rates given they are not able to take advantage of lower taxed foreign subsidiaries.
Out of favour are technology stocks, which tend to generate a lot of foreign income. They will benefit from repatriating the billions of dollars stranded in foreign subsidiaries, but they don’t stand to benefit as much from corporate tax reform as they already have lower tax rates. Also, a strong U.S. dollar will hurt earnings, as could a more protectionist environment. The Donald has specifically called out Apple for manufacturing their iPhones in China. He has also chastised Amazon, but more because they own the Washington Post and the Donald feels the newspaper has treated him unfairly.
While the U.S. grapples with the shocking election of Donald Trump, many worry the populist movement is global and Europe could be next. While this is a risk for 2017, much like the results from the U.S. election with both Germany and France holding general elections, we believe Europe has the potential to positively surprise markets next year.
Euro-zone countries have a more positive attitude towards the European Union (EU) and the Euro than the U.K., which has always been more ambivalent about the EU and never chose to adopt the Euro. In fact, in most Euro-zone countries, the Euro is more popular than the populist parties that want to scrap it. Even Italy, where Euro-sceptic parties cumulatively poll above 50% and on December 4th rejected Prime Minister Matteo Renzi and his constitutional referendum bid, still wants to keep the Euro.
While support for populist candidates has been rising, they are a long way from dominating. Case in point, while Italy was rejecting Prime Minister Renzi, Austria held their Presidential election the same weekend and voters rejected far right anti-establishment candidate Norbert Hofer in favour of the more liberal Alexander Van der Bellen.
France could be the key next year. The race for the Presidency will likely come down to two candidates: the National Front’s Marine Le Pen, and the Republicans’ candidate Francois Fillon. Le Pen is a populist and has promised to hold a national referendum to take France out of the EU (Frexit).
Fillon, on the other hand, is a conservative and wants to liberalize the economy and make France more competitive. Fillon, who compares himself to Ronald Regan and Margaret Thatcher, was the underdog in the battle to secure the center-right nomination; much like Donald Trump was in the race to become the Republican nomination. Unlike Trump, however, Fillon has a sizable lead in the polls, with nearly 70% support versus about 30% for Le Pen. If Fillon is able to get elected on a platform to reform France’s economy, European markets would likely follow American stock prices higher.
China doesn’t have elections to worry about next year, or anytime for that matter, but like most countries, a strong U.S. dollar is putting pressure on their currency. The Yuan fell to its lowest level against the U.S. dollar since 2008 last month. Although it’s mainly stable or even higher, against a basket of other major trading currencies, investors are concerned a weakening Yuan could increase the flow of capital out of China.
The Bank of China recently disclosed China’s foreign exchange reserves fell for the fifth straight month in November, declining $69 billion to their lowest level since March 2011. January is likely to be another rough month. Chinese citizens are allowed to take $50,000 out of China each year, and while most have already used up their quotas for this year, many fear outflows will spike when the quota resets early next year.
Last year, China’s FX reserves fell by $100 billion in January. While Trump has historically labelled China a currency manipulator for undervaluing its currency, lately the reverse has been case, with the Bank of China working to keep the Yuan from falling. The central bank has been increasing interest rates in order to strengthen the Yuan; but has done so cautiously, so as to not disrupt the housing market which has been a key source of strength for the domestic economy.
Chinese economic growth appears to have stabilized, but only because debt levels and government support for state-run enterprises have continued and reforms have been pushed to the background. China still has over $3 trillion in reserves, but if capital outflows continue to gather steam, China will need to either let the Yuan fall, continue to increase interest rates, or ramp up restrictions on capital flows. None of these options would be greeted warmly by the markets and is the reason many believe China remains the biggest threat to the world economy.
Another risk for China, of course is Donald Trump himself. Based on early impressions, China appears to be a prime target for the new administration. Trump appears to be using geopolitical issues as bargaining chips in dealing with Chinese leaders. Not only did The Donald take a phone call from Taiwan’s President, but Trump has openly questioned why the U.S. should be bound to the “One China” policy unless China is willing to deal on other issues, like trade.
Taiwan is an extremely sensitive topic for China, and Trump’s apparent willingness to use it as a bargaining chip is either very cunning, or extremely reckless. And this is really the issue with Trump. Is he a shrewd negotiator that will be able to gain concessions for an America that has been taken advantage of for years, or is he a narcissistic rookie who could plunge the world into a global trade war, or worse?
The issue is not only a geopolitical question either, but domestic as well. During the election campaign, Hillary Clinton described half of Trump’s supporters as a “basket of deplorables.” We suspect his support was broader than the uneducated sexists and racists Hillary and the democrats were eluding to. Trump’s support derived more from a middleclass, that had been largely forgotten by corrupt Washington elite which favoured a smaller government, more focused on restoring domestic prosperity and economic growth.
If corporate America believes Trump can be successful at driving domestic growth higher while not triggering World War III, confidence should continue to move higher and business investment will finally start to ramp up as corporations see the stability they need in order to make long term spending commitments. Business investment is needed in order for the recovery to be meaningful and sustainable, and confidence is the key catalyst required to make it happen.
Is the current increase in equities and bond yields (decline in price) sustainable? It’s too early to tell. Trump’s policies are reflationary in intent, but it is yet to be determined what the specific details of the policies will look like, whether he will be successful in getting Congress’ support in passing them and whether they will actually deliver the intended results.
We are bullish on corporate tax reform and deregulation. We are less optimistic on infrastructure spending and geopolitical policies like trade and globalization. Interest rates need to move higher and monetary policy is long overdue to start normalizing. The U.S. economy has moved beyond crisis mode so crisis-level interest rates and monetary policy are not warranted, and may actually be harming growth.
We don’t think investors should get ahead of themselves, however. Trump’s policies, at best, are only part of the solution. There is still too much debt in the World and the deleveraging process needs to run its course. Actually, to be more accurate, the deleveraging process in most countries needs to actually start. In the short term, the markets are susceptible to a pullback once reality sets in and markets more accurately start to discount the impact of the Republican agenda.
What did you think of November’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.