A “Bizarro Month” For Markets


Headlines This Month

NWM Asset Class Highlights

It was mainly a risk on month in September, with most assets classes finishing the month in positive territory.

Fixed income products returned positive results as short-term yields were virtually unchanged with 2-year Canada yields starting and ending the month at 1.19%.  10-year Canada’s actually rallied, with rates at the end of September hitting 2.54% versus 2.62% at the beginning of the month.

NWM Bond was up 0.4% for the month as credit spreads provided a positive return.

Positive credit spreads didn’t help high yield bond returns in September, however, as NWM High Yield Bond declined 0.2%. This was due more to the underperformance of one manager than the high yield sector itself.

Global bonds were higher again in September, with NWM Global Bond increasing 0.4%.  A fine result given the Canadian dollar rallied 2.2%.  A delay in Federal Reserve tapering and the prospect of continued capital flows into emerging market debt helped lift returns in this sector.

Mortgages were steady as always, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.5% and 0.6% respectively.

The preferred share market had a month of consolidation during September, dipping lower in the first week before recovering and eventually ending the month up 6 bps on price and up 44 bps on total return. NWM Preferred Share mirrored the market and was up 44 bps.

We continue to seek liquidity in rate-resets that have a high probability in getting extended and convert into the floating rate versions.

Canadian equities were stronger in September with the S&P/TSX gaining 1.1% (total return, including dividends), while NWM Strategic Income and NWM Canadian Tactical High Income were up 2.2% and 2.3% respectively.

In Strategic Income, we established new positions in Catamaran and CAE and added to our positions in Agrium and Canadian banks.  The cash position is just under 5%.  Presently about 10% of our Canadian positions are covered and just over 2% of our U.S. holdings.

As for Canadian THI, we continue to focus on put writing. We are constructive on the overall markets, but believe that as valuations start to get stretched there will be better entry points to leg into positions.

Foreign equities were stronger in September with NWM Global Equity up 2.5% versus +2.7% for the MSCI All World Index and 0.9% for the S&P 500 (all in CAD).  NWM U.S. Tactical High Income returned 3.6% in USD (which is about 1.4% in C$’s).

One of the strongest contributors to returns for the month was Brookfield Office Properties which was up more than 18% for the month as Brookfield Property Partners tendered an offer to consolidate holdings and purchase BPO.

The REIT market performed well in September with NWM Real Estate up 3.6%.

The alternative strategy funds were among the few in negative territory last month.  Gold slipped back into the red with bullion declining 6.8% in Canadian dollar terms.  Gold stocks were down even more, with NWM Precious Metals declining 9.4% – a disappointing result given the delay in Federal Reserve tightening and concerns regarding a possible U.S. default.

A calming in the situation in Syria, while positive for mankind, was negative for gold.  NWM Alternative Strategies decreased an estimated 1.4%.

September In Review

By Rob Edel, CFA

Equity markets were stronger in September with the S&P/TSX up 1.1%, while S&P 500 and Dow Jones Industrial Average rallied an impressive 3.1% and 2.3% respectively. The MSCI All World Index soared 5.0%.

It was a “Bizarro World” month in September, with global and domestic events taking some unexpected turns.  The crisis in Syria calmed considerably, as a Russian brokered deal that would see President Assad give up his chemical weapons appears to have permanently shelved plans for a U.S. missile strike.

In addition, new Iranian President Hasan Rouhani has tentatively signaled a willingness to strike a deal with the U.S. on nuclear enrichment that could result in the lifting of economic sanctions and normalized diplomatic relations with the U.S.

Such developments have emboldened President Obama to proclaim in a recent address to the U.N. General Assembly that solving the Iranian issue was a priority for his second term, and even threw in the establishment of an independent Palestinian State for good measure.

“Crazy talk,” I know.  Many U.S. presidents have made similar pledges and failed miserably to solve a Middle East problem that appears to have no solution.  Still, removal of the threat of military conflict in the Middle East is good for the markets – and mankind in general.

It’s likely that Russia and Iran are just playing for time and no substantive Middle East solutions will be made, but the markets like it for now.

MMC-2013-09 Syria Plan

Perhaps the Syrian crisis wasn’t that much of a Bizarro event.  It was clear last month that Obama didn’t have the support of the American people to attack Syria and Congress was unlikely to backstop him.  The Russian plan was a convenient out.

What was really Bizarro, however, was the decision in mid-September by the Federal Reserve to stay the monetary easing course and continue purchasing $85-billion a month in U.S. Treasuries and mortgages.  Nobody expected that.

The markets had already started to come to terms with a gradual tapering.  All the heavy lifting was done.  Yes, economic growth has remained stubbornly low and higher interest rates were a concern, but surely this was factored in when the Fed tipped the market that QE would be scaled back in the near future?

Fortunately, this was taken by the market as a good surprise. As was the announcement in early October that Janet Yellen will be the White House’s pick to succeed Federal Reserve Chairman Ben Bernanke next year.

Mrs. Yellen is a known monetary “dove” and is likely to err on the side on more monetary stimulus rather than less.  The market likes monetary stimulus and is hooked on low rates.  What the market may be missing in its exuberance is why the Fed felt it necessary to back away from tapering.  We offer three possible explanations.

One: with Bernanke on his way out, why not leave it to the new Chairman to shape future Fed policy.  Two: economic growth has slowed and higher interest rates threaten to derail an emerging recovery in the housing markets.

And finally three: the Fed was concerned gridlock in Washington could result in a government shut down and potential debt default as Congress is unable to pass a budget or raise the debt ceiling. Good call on their part, as this is exactly what appears to be taking place.

MMC-2013-09 Markets soared on the report of continued stimulus part 1

MMC-2013-09 Overestimating growth

MMC-2013-09 Quantitative Easing (QE) & the Stock Market

We thought the passing of a budget and raising of the debt ceiling was going to be a non-issue. 

Washington took a beating the last time Republicans and Democrats battled over raising the debt ceiling and the U.S. lost their triple-A debt rating (not that anyone actually believes in debt rating anymore) as a result.

Surely Congress had learned their lesson.  Apparently not.

The deadline for passing a budget came and went, resulting in 800,000 non-essential federal workers being furloughed.  Of more concern, however, is the impact this impasse could have on ability of the U.S. to increase the Federal debt ceiling.

The U.S. hit its $16.7-trillion debt limit in May and is projected to have only $30-billion cash on hand by October 17.  Without an increase in the debt ceiling, the U.S. will not have the ability to pay its bills and would likely default by the end of the month.

J.P. Morgan Chase estimates the government shutdown is likely to shave 0.12% off fourth quarter GDP growth; disappointing, but hardly a disaster.

In June of 2011, however – the last time the Congress battled over increasing the debt ceiling – the Dow shed 16% over the following months.  Already, consumer confidence is plummeting.

MMC-2013-09 Out of room part 1

MMC-2013-09 Out of room part 2

MMC-2013-09 Out of room part 3

While it could go down to the wire, we don’t think the U.S. will default.  Republicans are starting to feel the heat, with a recent WSJ/NBC News Poll finding 53% of Americans blame Republicans for the impasse versus only 31% who blame Obama.

Republicans are using the debt ceiling as leverage to gain concessions on government spending, which would be a good thing.  The Congressional Budget Office recently projected the U.S. federal debt will hit 100 percent of GDP in 25 years unless entitlement spending (Social Security and Medicare) is controlled.

At its current rate of growth, entitlement spending alone could actually equal total Federal revenue by 2030.  Perhaps the real Bizarro event will end up being that a deal is struck that helps address this.  I know… crazy talk.

Any resolution would be good for the markets at this point, and we would expect a short relief rally on any news of a deal.

MMC-2013-09 Federal spending projection through 2050 part 1

MMC-2013-09 Seeing Red

As Bizarro as the notion of the U.S. finally addressing their long-term debt problems might sound, Japan proved it can be done, as Prime Minister Abe announced plans in early October to go ahead with a previously announced 3% sales tax hike.

Abe believes, as do we, the increase is essential in order to contain Japan’s soaring Federal debt levels.  It is estimated that increasing the tax from 5% presently to 8% in April will raise about ¥8-trillion (US $80-billion) a year.

The decision to further increase the tax to 10% in October 2015 will depend on economic conditions – and if Abe is still PM, of course.  We say this because the sales tax is hugely unpopular in Japan.  Initially established at 3% in 1989 and raised to 5% in 1997, Governments responsible for its introduction and growth subsequently suffered considerably at the polls.

It’s so far so good for Abe right now.  Stronger economic growth and the promise of more stimulus to cushion the blow from a sales tax increase has Abe’s approval rating above 50% in opinion polls.

In Europe, German Chancellor Merkel is done worrying about opinion polls for a while.  While failing to get an outright majority by a mere 5 seats, Merkel’s Christian Democratic Party received a better than expected 42.5% of the vote in Germany’s recent Federal Election, the party’s strongest showing in 20 years.

The bad news was that their previous coalition partners, the Free Democratic Party, received less than the required 5% support and thus did not win any seats in the 630 seat parliament.  Merkel will likely strike a new coalition deal with the Social Democrats, who came in a distant second place.

Fortunately for Europe, the Social Democrats share Merkel’s views on European integration and her policies on the Euro-zone crisis.  Unfortunately, they are also against excessive austerity directed at southern European countries in return for bailout funds.

An easing of austerity could be good for markets in the short term, but bad for Europe in the long term as Europe needs to deleverage and is falling behind versus the U.S. in this area.

MMC-2013-09 Debt supercycle divergence

MMC-2013-09 Selective Rush

Overall, geopolitical events provided a positive boost to global capital markets in the month, as did the Fed’s unexpected delay in tightening monetary policy.

Events in Japan and Germany were also positive, but all could be for not if the U.S. Congress is not able to come to some kind of consensus on a Federal Budget and increase in the debt ceiling.  It will happen.  The question is how much damage will be done before a done deal?

The U.S. Economy

MMC-2013-09 Economic Growth-Table-US

Strong manufacturing numbers in September and an expanding services sector led many analysts to question the Fed’s decision to delay tapering.  Lower consumer confidence and a pull back in business investment due to the budget ceiling debate could slow economic growth over the coming months however.  Let’s call it a draw this month.

MMC-2013-09 Employment-Table-US

The employment situations report for September was delayed due to the government shutdown.  Perhaps this was a good thing as the ADP National Employment Report indicated private job growth may have slowed last month.

Delayed economic information is another factor that could increase uncertainty in the markets.

MMC-2013-09 Inflation-Table-US

Despite predictions that it should be moving higher, inflation continues to remain low and is potentially one of the reasons behind the Federal Reserve’s decision to delay tapering.

The Federal Reserve is terrified of deflation and a slowdown in an already weak economy could easily tip the scales towards deflation.  Normally low inflation is a good thing, but when it is due to an economy producing well below its capacity, low inflation can also be a warning sign.

Low medical costs are an example of this.  With medical prices increasing at their slowest pace in 50 years, this should be welcome relief to a government struggling to fund soaring deficits.  The likely cause, however, is due to the impact the recession has had on company health plans and the move by employers to shift more costs to their employees via increased co-pays.

MMC-2013-09 The price is tight part 1

MMC-2013-09 Eyeing inflation

MMC-2013-09 On the mend

MMC-2013-09 On the mend part 2

Notes: the inflation chart measures prices paid by consumers and on their behalf by employers and the government; procedure prices represent the high and low in-network allowed amount for the service in each market.

MMC-2013-09 Consumer Confidence-Table-US

Consumer confidence turned sharply lower in September with the University of Michigan Index hitting a 5-month low.  Uncertainly over the government shutdown and debt ceiling debate are likely major contributors.

MMC-2013-09 University of Michigan consumer sentiment part 1

MMC-2013-09 Sinking feeling

MMC-2013-09 The Consumer-Table-US

With consumer confidence declining, retail spending predictably eased in August, and if same store sale indicators are a predictor of future sales (which they are), retail sales are unlikely to recover anytime soon, as they posted weak results in September.

In fact, early forecasts for Christmas are predicting the holiday season will be the weakest since 2009, with ShopperTrak estimating only a 2.4% increase in November and December sales versus 3% last year.  On the positive side, a stronger dollar means import prices will be lower for Americans.

Lower prices may be helping consumer affordability, which is a good thing because income levels declined during the financial crisis and have been slow to recover.

After four years of declines that pushed pay cheques to their lowest levels in almost twenty years, incomes declined a statistically insignificant 0.2% last year.  During the roaring 1990’s, incomes soared almost 15% and peaked in 1999 at an inflation adjusted median annual household income level of $56,080.

Presently, incomes remain over 8% below 2007 pre-recession levels of $55,627.  The good news is a recovering housing market and rising stock market has resulted in household wealth hitting an all-time high in the second quarter.

Inflation-adjusted, however, net worth is still about 4% below peak levels as Americans have recovered 80% of the wealth lost during the financial crisis.

MMC-2013-09 Climbing back, but slowly part 1

MMC-2013-09 Climbing back, but slowly part 2

MMC-2013-09 Change in U.S. median household income

MMC-2013-09 Paychecks largely stabilized last year

*Includes non-profit organizations.  †Directly held and indirectly held. 

Sources: Federal Reserve (balance sheet data), Freddie Mac via the Federal Reserve Bank of St. Louis (mortgage rates); Commerce Department (income, spending);  Conference Board via Thompson Reuters (confidence).

MMC-2013-09 Housing-Table-US

While prices continue to march higher and sales of existing homes reached their highest level since 2007 in August, the buying frenzy has definitely eased as higher interest rates have reduced buyer affordability.

With the inventory of unsold homes remaining low and housing starts continuing to trend higher, we remain constructive in regards to the U.S. housing market.

MMC-2013-09 Cooling down part 1

MMC-2013-09 Cooling down part 2

MMC-2013-09 Trade-Table-US

No U.S. trade data in August due to the government shut down.

We are still positive in regards to the U.S. economy.  Manufacturing remains healthy and the housing recovery, though slowing moderately, remains intact.  Too bad we couldn’t get a reading on employment.

Lower consumer confidence is a concern, however, and could lower fourth quarter economic growth.  Interest rates need to remain low and Congress needs to get their act together.

The Canadian Economy

MMC-2013-09 Economic Growth-Table-CAN

As predicted, the Canadian economy recovered in September with the resolution of the construction strike in Quebec and re-building activity from the severe flooding in Alberta.

Manufacturing activity continues to expand, most likely due to a stronger U.S. economy and increased auto sales.  At its present pace, Q3 economic growth should easily exceed Q2’s weak 1.7% growth.

MMC-2013-09 Employment-Table-CANUnlike the U.S., we did have employment numbers for Canada in September, and they were pretty good.  Canada created nearly 12,000 new jobs after last month’s blockbuster month.  Even better, the unemployment rate decreased to 6.9%, its lowest level since 2008.

All the gains were full time and came from the private sector.  The decline in the unemployment rate was almost entirely due to a decrease in the number of youth (15-24 years old) looking for work.

MMC-2013-09 Inflation-Table-CAN

Like the U.S., inflation remains very low in Canada.  Only clothing and footwear increased above the Bank of Canada’s 2% threshold and increased retail competition is likely to curtail prices in this sector over the near term.

MMC-2013-09 Consumer Confidence-Table-CAN

MMC-2013-09 The Consumer-Table-CANConsumer confidence moved higher in September and retail sales rebound strongly in July after June’s decline.

MMC-2013-09 Housing-Table-CAN

The Canadian housing market continues to recover from the latest tightening in the mortgage rules, with Vancouver, Calgary, Edmonton, Winnipeg and Saskatoon leading the way.  Sales are still considerably below peak levels, however, and some of the recent strength maybe due to buyers scrambling to lock in low mortgages rates before rates rise.

MMC-2013-09 Trade-Table-CAN

On a positive note, exports are starting to increase, though unfortunately not as much as imports.  A stronger U.S. economy is still the best recipe for turning Canada’s trade deficit back into a surplus.

Canada’s economy continues to plod along.  Not too strong, but strong enough.  The housing market remains resilient and continues to defy the doomsayers.  Our fortunes hinge on what happens in the U.S., however.

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 fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.

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