2014: Good Returns Mean More Volatility - Nicola Wealth

2014: Good Returns Mean More Volatility


The NWM Portfolio

It was once again a risk-on month in December as positive economic news drove equities and yields higher.

Canadian equities had a strong month in December with the S&P/TSX gaining 2.0% (total return, including dividends), while NWM Strategic Income and NWM Canadian Tactical High Income were up 2.4% and 1.2% respectively.  For the year, the S&P/TSX gained 13.0% while NWM Strategic Income and NWM Canadian Tactical High Income increased 23.5% and 23.2%.

NWM Strategic Income’s cash position is currently below 3%, the lowest since the pool’s inception.  Approximately 10% of our Canadian positions are covered and just under 1% of our U.S. holdings.

Foreign equities were also stronger in December with NWM Global Equity up 2.1% versus 2.2% for the MSCI All World index and 2.5% for the S&P 500 (all in CAD).  For the year, NWM Global Equity gained 30.7% versus 36.2% for the MSCI All World index and 32.0% for the S&P 500 (all in CAD).

All our external managers were all up in December, with the exception of the Guardian Asia Growth and Income Fund, which was down 0.5%.  The Guardian fund was also a laggard for the year, gaining only 9.3%.  Given the Shanghai Composite was up only 5.8%, softer returns are not unexpected.

In general, the MSCI World Index was a tough act to follow in 2013, and Edgepoint, with a 46.3% return, was our only external manager able to beat the index.  NWM U.S. Tactical High Income returned 1.2% (approx. 1.3% in CAD) in December and 12.3% (approx. 20.2% in CAD) for the year.  While the pool lagged the market, this is a pretty good return given the covered call and naked put writing strategy employed by the fund.

The REIT market was stronger in December with NWM Real Estate up 0.5%.  For the year, the fund was down -2.8%.  SPIRE LP was up an estimated 10.2% for the year while SPIRE US LP was up an estimated 14.2% (approx. 22.3% in CAD). Final returns for the SPIRE LPs will not be available until later in the month.

Interest rates moved higher and bond prices lower with 2-year Canada yields ending the month at 1.14% versus 1.10% at the start of the month.  10-year Canada’s backed up even more, ending the month at 2.76% versus 2.56% on November 29.  For the year, the 2-year Canada’s were virtually unchanged, while the 10-year yields started the year at 1.80% and backed up nearly 1%.

NWM Bond was up 0.6% in December as our short duration and alternative manager strategy is starting to bear fruit.  For the year, the NWM Bond returned 2.9%.  Respectable given what interest rates did, but we would expect more in 2014 as the impact from our alternative managers will have a full year to impact the performance of the fund.

Credit spreads provided positive returns in December, as NWM High Yield Bond increased 0.4%. For the year the pool was up 6.1%.  Again, a good result given the increase in interest rates.  Not surprisingly, our best performing manager was our long/short mandate where the manager carries little, if any, interest rate risk.

Global bonds were also higher, with the NWM Global Bond increasing 0.7%.  Again this month (and probably next month as well), the weak Canadian dollar was a positive contributor to these results.  For 2013, NWM Global Bond was up 4.2%.

Mortgage returns were steady as always, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.6% respectively for December and 4.4% and 7.5% for the year.

NWM Preferred Share returned -1.2% for the month of December and -1.56% for the past year, outperforming the S&P/TSX Canadian Preferred Share Index ETF which returned -1.52% and -3.01% respectively.

The end of year sell-off was mainly driven by retail tax loss selling and further highlighted by the light volume. On a relative basis, we are constructive in the preferred share market as it has lagged corporate bonds in rebounding from the summer sell-off and preferreds currently trade at attractive yields relative to their corporate counterparts.

The fear of interest rates rising in Canada has abated and is reflected in TD’s decision to redeem their Series AA as it believes that it can issue shares with a lower coupon. We are currently positioning the portfolio to reduce redemption risk in the marketplace as we anticipate approximately $8.6 billion in preferred shares (of a $63-billion market) will be called in 2014.

NWM Alternative Strategies had a decent month in December, increasing an estimated 0.8%.  For the year, the pool is up an estimated 5.7%.  These estimates can’t be confirmed until later in the month.

As mentioned above, it was a rough year for gold.  Bullion was down 0.6% in December and 22.6% for the year.  Gold stocks did even worse, with NWM Precious Metals declining 1.9% in December and 42.5% for the year.

December in Review

By Rob Edel, CFA

Equity markets finished off the year on a positive note with the S&P 500 and Dow Jones Industrial Average up 2.5% and 3.2% respectively (in Canadian dollars) in December.  In Canada, the S&P/TSX posted a respectable, though slightly lower, 2.0%.

This pretty well sums up the year in general, with U.S. markets handily outperforming Canadian stocks.

In most years, one would be quite pleased with the 13.0% annual return delivered by the S&P/TSX, but compared to the 32.0% advance in the S&P 500, Canadian investors may feel a little short changed.

Even European exchanges managed to more than triple returns in Canada, with the Stoxx Europe 600 increasing 35.7% for the year.  Canada, in fact, was one of the worst-performing equity markets amongst the major developed exchanges in 2013, with only Australia’s ASX 200 and China’s Shanghai Composite trailing with meager 12.0% and 5.8% returns in Canadian dollar terms.

In Australian dollars, even Aussie investors did better than Canadians, with the ASX 200 increasing 22.0% in local currency terms.

Trailing even further were fixed income securities.  With interest rates moving higher in the second half of the year, investors were keen to shed interest rate risk.  Credit risk remained attractive, buffering some of the down side for credit-related products such as corporate debt and mortgages, but government paper fared poorly.

Emerging market equities and debt also struggled due to concerns U.S. Federal Reserve tapering would sap global liquidity from countries hooked on cheap capital.  The worst performing asset class, however, was commodities, and gold in particular.

Gold closed the year lower for the first time since 2000 with its worst loss in 3 decades.  Low global inflation and improved economic growth has tarnished gold’s reputation and role in investment portfolios.

MMC-2013-12-Keeping it sample

So much for 2013.  What can investors expect in 2014?  In order to determine where to deploy one’s capital, it is important to consider valuations and the health of the economy.

While we wouldn’t expect a repeat of 2013, conditions are good for another strong year in equities, even in Canada.  We expect more volatility, however, and highlight some potential risks to the market returns below.


Looking first at valuations, after such a strong year in 2013 one couldn’t be blamed for thinking a correction is overdue.  We do not, however, see the typical signs one would expect of a market ready to roll over.

As Morgan Stanley recently pointed out in a research report entitled U.S. Year Ahead 2014, it is not uncommon for U.S. stocks to deliver solid double digit returns.

In fact, nearly 1 in 3 years since 1897 have resulted in either the Dow or S&P 500 rising more than 20%.  It’s also not uncommon to follow up a strong year with another strong year.  LPL Financial’s Jeff Kleintop recently pointed out that the years following a 25-30% return on the S&P 500 usually deliver a double-digit return, with the average being about 12%.

MMC-2013-12-Anual Price Performance

As mentioned last month, valuations have risen, but by most measures they are not exceptionally high.  While forward price earnings ratios (P/E multiples) are over 5-year and 10-year averages, they are still comfortably below 15-year averages.

MMC-2013-12-S&P 500 Forward 12-Month P-E Ratio

Also, the rally in 2013 was broad based, with all sectors ending the year in positive territory.  While defensive sectors, such as utilities and telecommunications, were strong out of the gate in 2013, it was economically sensitive stocks, such as consumer discretionary and industrial, that took over and led the market higher.

MMC-2013-12-Green Light

Also performing well were small cap stocks and inexpensive stocks.  A rising tide lifts all ships, such that when the market perceives the economy is getting stronger and growth is plentiful, investors see the highest returns in companies that were hurt the most in the recession.

Alternatively, when a market rally gets long in the tooth and the economy starts to slow, investors tend to gravitate to big defensive companies, no matter what the price.

You want to own companies that are still able to grow their earnings, even in a slowing economy, and this tends to be an ever decreasing number of high quality stocks.

Based on market action in 2013, there would appear to be abundant economic growth. 

MMC-2013-12-Anatomy of a Rally


And we would agree, the global economy ended the year on a strong note and looks to continue strengthening in 2014.

The U.S. Economy

Third quarter U.S. real GDP was again revised higher to a final 4.1% increase, and while inventory re-stocking contributed much of the gain, consumer spending was also revised higher.

MMC-2013-07-Looking Up

While estimates for the fourth quarter are more subdued, growth in 2013 is still expected to come in around 2.4%, higher than 2012’s 2.2% growth.  For 2014, many are expecting GDP growth to be even more, and could top 3.0%.

For one thing, it is estimated that fiscal drag (tax increases) took about 1.0%-1.5% out of U.S. economic growth last year and will be much less in 2014.  Also, the housing market continues to recover and should also contribute to growth in 2014.  In addition, this might be the year in which business spending rebounds.

Gridlock in Washington and global economic uncertainty has made many companies reluctant to spend money the past few years.  With a budget deal signed and global economic growth rebounding, many companies could be prompted to invest for future growth.  2014 could be the year the economy finally lives up to expectations.

MMC-2013-12-Falling Short

Of course, comprising approximately 70% of U.S. GDP, consumer spending is what drives the U.S. economy, and Americans need to be in a buying mood for economic growth to finally gain traction.  Debt service ratios are at record low levels and could be indicating an end to the consumer deleveraging cycle.

Strong real consumer spending data in October and November appears to back up that idea, with the Bank of Tokyo-Mitsubishi’s Chris Rupkey estimating consumer spending could hit 3.6% in the fourth quarter, the strongest growth since 2010.  Deutsche Bank’s Joe LaVorgna believes this could translate into real GDP growth of 4% in Q4.

Offsetting this optimism has been a poor holiday shopping season, with retailers needing to heavily discount inventory to lure shoppers into stores.  While this is a concern, we would point out the weather outside has also been, dare we say it, frightful.

MMC-2013-12-Household debt service ratios at best level in decades

One of the missing ingredients in the recovery from the great recession has been a slow healing labour market.  Job growth has been unusually slow as the U.S. has struggled to put people back to work.

Most of the new jobs that have been created are in low-paying sectors, and workers who have been able to keep their jobs have seen their wages barely keep pace with inflation.

MMC-2013-12-Gaining Ground

A recovery in the job market is crucial to any economic recovery, and we may finally be seeing some progress.   The unemployment rate has been moving consistently lower and the past four months have seen the U.S. average over 200,000 new jobs a month.

The end of 2013 sees the expiration of the temporary federal program to extend State unemployment benefits beyond 6 months, which could also result in a further drop in the unemployment rate.

North Carolina cut the program last summer and this resulted in the State’s unemployment rate diving lower.  With no benefits, jobless workers were likely more motivated to settle for any job.

Also, in order to receive unemployment benefits, workers have to actively look for work, even if it is likely they will not find any.  Now that there are no benefits, why bother continue to look?  Workers likely dropped out of the workforce, lowering the participation rate, and effectively lowering the unemployment rate.

Maybe this isn’t so much a sign of a recovering economy as it is a growing awareness of the real state of the job market.  A lot of the workers who have been unemployed for an extended period of time may never work again.

The job market is getting stronger in the U.S., and this is a good thing.  It just might not be quite as strong as the numbers indicate.

MMC-2013-12-Tar Heel Taper

A stronger U.S. economy would be a welcome sight for the capital markets.  Though valuations are not in bubble territory, they are stretched.

Multiple expansion drove returns last year in the U.S. and Europe, and while there is room for them to move higher, for the stock market to have another positive year, earnings growth needs to lead the way.

Market action last year and signs of economic growth give us confidence that the stock market will continue to offer good returns in 2014.

MMC-2013-12-Deconstructing 2013s Global Equity Makert Returns

But there are risks, and just like a weak economy doesn’t always mean weak equity returns, a strong economy doesn’t always translate into strong equity returns.  More job growth and wage inflation would be great for the economy, but perhaps not so much for corporate earnings.

One of the reasons corporate earnings have been  strong and profit margins are at record levels is companies have been able to be particularly stingy when it comes to hiring and paying workers.

The chart below shows the gap between price inflation and unit labour cost to be a very strong predictor of profit margins.  This makes sense given wages are a major input cost for companies, and if wages grow less than inflation, margins should expand.  If wages start to move higher, however, the reverse is also true.

MMC-2013-12-The Price-Wage inflation gap drives profit margins

A stronger job market could also prompt the Federal Reserve to tighten monetary policy.  Already, the Fed surprised the market in December by announcing it would begin tapering the $85-billion a month bond buying program starting in January.

The modest $10-billion reduction is believed to be the first step in winding down the program by the end of 2014.  The Federal Reserve, however, has been very explicit in stating that tapering does not mean overnight interest rates are going to move higher anytime soon.

In fact, when announcing the tapering, the Fed stated that they expect overnight rates to remain at near zero, “well past the time the unemployment rate declines below 6.5%.”  The Capital Markets have, so far, taken Chairman Bernanke by his word, but a stronger job market will be a test, particularly if inflation starts to heat up.

So far, deflation is a bigger threat than inflation, and as mentioned above, there is still a lot of slack in the labour market.  Inflation is a key variable to watch, however.  At any sign of inflation, bond investors will head for the hills and yields will move higher.

Already we are seeing some protein prices, particularly red meat, move higher.  Medical costs are also at risk of moving higher, as are housing costs (rents).  The Fed may keep short-term rates low, enjoying the economic benefit negative real interest rates have on an overleveraged economy, but it can’t control long term rates.

Unless, of course it implements a new bond buying program.

MMC-2013-12-The Low Down

Best case scenario, the current economic recovery continues to slowly unfold.  Interest rates move up gradually and the job market continues to gain traction.  Higher rates are not necessarily bad for stock market valuations, especially when interest rates are as low as they are presently.

Depending on the study, 10-year bond yields would need to hit 5-7% before negatively impacting valuations, and U.S. Treasuries are presently around 3%.  We have a long way to go.

Too fast a recovery, however, and the market could start anticipating higher rates and this could impact retail stock and bond market returns.  Just the threat of this will likely make markets more volatile in 2014.

There is also the risk that the Federal Reserve tightens too early and snuffs out the current economic momentum, but we believe it is more likely to err on letting inflation accelerate than risk deflation.

Of course, the worst case scenario is that it gets both, namely inflation and a stagnating economy.  While always a risk, given the current trends, we don’t see this as a big risk for 2014.

MMC-2013-12-Correlations between weekly stock returns and interest rate movements

The European Economy

Europe is also looking to have a better year in 2014.  After contracting an estimated 0.4% in 2013, many forecast the Euro-zone economy could expand approximately 1% in 2014.

Like the U.S., fiscal drag should be less of a headwind this year, and the new German coalition government could actually become more stimulative if it goes ahead with a planned increase in the minimum wage rate.

Unfortunately, 1% GDP growth is unlikely to be enough to reduce double-digit unemployment rates in Greece, Spain and Italy.  The Euro-zone economies may stabilize, but without major reform and wage deflation, it will be hard to alter the competitive landscape for inefficient, over-paid southern Euro-zone peripheral countries.

Even France risks increased scrutiny for its lack of movement in implementing needed economic reforms.  The framework for a banking union was recently hammered out in the Euro-zone, but the resolution fund (the equivalent of our FDIC) is estimated to take 10 years to reach its target of €55-billion.

Until then, not much changes, with national governments looking after their own banks.  Also, €55-billion seems a pretty small amount given dealing with the Irish banking crisis would likely have consumed the entire fund.

2014 should be a less volatile year for Europe, but it remains a concern.

MMC-2013-12-Slow Lane

The Asian Economy

Unlike Europe, many fear China may be just at the start of its own debt problems.  While China’s GDP is estimated to grown 7.6% in 2013 versus Beijing’s target of 7.5%, it is lower than 2012’s growth of 7.7%.  Despite decelerating growth, China continues to take on more debt, particularly local government and corporate debt.

Chinese economic growth is geared towards infrastructure spending and exports as opposed to developed country economies, like the U.S., that are dominated by the consumer.  With the global recession slowing export demand, infrastructure has been the main driver of economic growth in China.

This is fine if the infrastructure being built eventually generates a positive return, but this is not always the case.  Many of the projects being built will never become profitable, and much of their debt will eventually have to be written off.

China needs to rebalance its economy, but the trade off to doing so will mean even lower economic growth.

MMC-2013-12-Home-Grown Problem

So far, we are seeing some signs Beijing is moving in the right direction, but it is far from an easy task.

Beijing has attempted to curtail credit growth, but this has just shifted borrowing to the shadow banking system.  Also, concerns over bank defaults has resulted in a lack of liquidity in the interbank market, with interest rates spiking dramatically and requiring Beijing to add liquidity to the system.

In order to increase consumer spending, Beijing is trying to develop a social safety net, and recently added 500 million people to its public pension system with a goal to have full coverage in 6 years.

In theory, if Chinese workers feel they don’t have to save as much for retirement, they will spend more today.  Of course, a public pension system is expensive, especially since China has not funded any of their future obligations.  Barclay’s estimates funding the public pension could add 35% to China’s debt-to-GDP ratio.

Bottom-line?  Growth in China is more at risk of coming in below target than surprising on the upside, and recent Chinese equity returns reflect this.

MMC-2013-12-Watch the spikes

Japan could only wish for such problems.  Debt in China is still relatively low, giving Chinese leaders options.  Not so in Japan.

Given the size of their government debt, Japan needs to grow and 2014 could be a make or break year.  At 144% of GDP, Japanese government debt is the highest in the developed world save for Greece, and a strong argument could be made that Greece is no longer part of the developed world.

It is estimated Japan needs economic growth of at least 3% in order to stabilize its debt levels.  Over the past 10 years, Japan has managed real GDP growth of about 0.9%, while deflation has taken away all of this and more, resulting in a negative nominal GDP growth.

Aggressive monetary policy can help generate inflation, and Japan is seeing some recent success with inflationary expectations creeping higher.  A weak Yen has also helped, making Japanese exports more competitive.

Real growth, however, will need real structural reforms (Prime Minster Abe’s “third arrow”) and there is some debate as to whether this will be possible.  Japan is playing a dangerous game and if investors start to lose faith in the Japanese bond market, the world’s third largest economy could be in for a rough year.

MMC-2013-12-Japan at risk

The Canadian Economy

So where does all of this leave Canada?  Like the U.S., the Canadian economy looks to be finishing 2013 on a strong note with October GDP up 2.7% versus last year.  As a result, GDP growth for 2013 should come in below that of the U.S. at just over 2%.

While stronger global economic growth in 2014 (particularly in the U.S.) should benefit Canada, we would expect GDP to again lag that of the U.S.  We don’t see a housing market crash in the cards for Canada (interest rates should remain steady and employment firm), but new construction should slow, and this will provide a headwind for economic growth.

Also, consumer debt remains high and some containment will also hurt growth.  On the positive side, Americans like Canada, and hopefully they will buy more of our goods.

MMC-2013-12-Americans views of other countries

The recent decrease in the Canadian dollar should further help our exports and drive Canada’s balance of trade back to surplus position.  Goldman Sachs, in fact, believes the Canadian dollar could trade down to 88 cents.  While we are not sure the loonie will sink down to these levels, the Bank of Canada probably wouldn’t be too upset if this happened.

Like the Federal Reserve, the Bank of Canada is uncomfortable with the present low inflation rate and is unlikely to raise interest rates until it moves back towards its 2% target.  Expectations that the U.S. will raise rates before Canada is one of the key drivers behind the weak Canadian dollar.

It’s not all bad for Canada, however.  We still have relatively low government debt compared to our developed world colleagues and should be able to leverage off stronger GDP growth in the U.S.

While Goldman Sachs is not too keen on the Loonie, foreign Central Banks are loading up, with official holdings of Canadian dollars increasing 23.6% year-to-date (as of Q3/13) according to the IMF.  Loonie holdings, in fact, were up more than any other major currency, despite being down nearly 8% against the U.S. dollar this year.

Investors might not like it, but the Central Banks do.  Kind of reminds us of a shiny yellow metal we know. Anything in the 90 to 95 cent range for the Canadian dollar is a good long-term level in our books.

MMC-2013-12-GDP growth, gross debt to GDP and borrowing costs

As for investment returns, equity valuations look fair in Canada and slightly more favourable than U.S. stocks.  The problem in Canada, however, is there is not as much to choose from and the S&P/TSX is dominated by the financial, energy, and materials sector.

We think there are great companies to own in all three sectors, but not in the concentration dictated by the index. We continue to look for companies that are able to grow their dividends and free cash flow and we are particularly interested in companies with direct exposure to the U.S. economy.

As for fixed income investments, we continue to keep interest rate risk as low as possible, preferring to earn our return through prudent credit exposure.  It’s an uncertain world and risks remain high.  Asset class diversification is key to controlling risk in this environment.

MMC-2013-12-Developed Market Countries

Let us know your thoughts on December’s market activity 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.