Highlights This Month
- Why October’s quick reversal in equity markets?
- The end of QE and its impact on interest rates.
- Risk of Eurozone recession looms with possibility of deflation.
- What’s the impact of Japan’s push for a weaker Yen?
- Economic frustration in Europe rises to a boiling point.
- Low interest rates and strong equity markets predicted.
- The U.S. economy boosted by military spending and lower trade deficit.
- A record winning streak for U.S. economic growth.
- Lower oil prices — good inflation or bad inflation?
- Retail federation expects Christmas will bring strong sales.
- Why shouldn’t Canadians be alarmed by the impact of low oil prices?
- Canadian employment rate lowest in six years.
- Canada’s housing market continues to defy gravity.
The NWM Portfolio
Returns for NWM Core Portfolio were up 0.7% for the month of October. 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.
Short-term interest rates moved lower in October with 2-year Canadas starting the month with yields of 1.12%, and ending the month at 1.02%. 10-year Canadas also rallied, starting the month with yields of 2.15% and ending the month at 2.05%. NWM Bond was down 0.1% as a couple of our more credit-oriented managers underperformed.
High yield bonds were higher in October with the NWM High Yield Bond up 0.5%. Credit spreads in Canada widened during the month, particularly energy issuers. A stronger U.S. dollar helped increase returns from our un-hedged U.S. high yield managers.
Global bonds were up higher in October, with NWM Global Bond increasing 0.5%. The weaker Canadian dollar likely helped returns.
The mortgage pools continue to deliver steady returns, with the NWM Primary Mortgage and the NWM Balanced Mortgage returning 0.4% and 0.5% respectively for October.
NWM Preferred Share was up 0.1% for the month of October versus the BMO S&P/TSX Laddered Preferred Share Index ETF, which was down 0.08% and the iShares S&P/TSX Canadian Preferred Share Index ETF, which was up 0.32%.
With noticeably lower volume during the month in the secondary market, we saw more opportunities in the primary issuance market for returns. We participated in three primary offerings in the month with all three performing well.
We will continue to look for more opportunities in the new issuance market as we see further upside potential with dwindling supply from further redemptions.
Canadian equities were weak in October with the S&P/TSX losing 2.1% (total return, including dividends), while NWM Strategic Income was up 1.1% and NWM Canadian Tactical High Income Fund gained 2.2%.
The cash position in the Strategic Income fund is currently about 1.6% and approximately 8% of our Canadian positions are covered along with 6% of our U.S. holdings. The cash position is down slightly from last month, but the covered call percentages are up.
Volatility spiked in mid-October as the market corrected, and while volatility retreated as the market quickly recovered, it still remains above levels experienced earlier in the month. As such, we continue to look for opportunities to write covered call options.
Recent trades include reducing our holdings in Rogers Communication and establishing a new position in insurance company, Industrial Alliance. We also sold Cenovus, Cameco, and Baytex, and purchased Vermilion, Whitecap, and Canadian Natural Resources. These trades were executed in order to generate taxable losses in the fund.
On the U.S. side, we added McKesson and Bristol Myers and trimmed Pfizer and Mylan Labs.
With the Canadian Tactical fund, approximately 61% is invested in Canadian equities, against which 50% has call options written.
New positions were added in WSP Global Inc., KP Tissue, and CCL Industries. Presently, 7% of the fund is in high yield bonds, 10% is held in NWM Balanced Mortgage, and 21% is in the PIMCO Monthly Income Fund. The pool has also written put options on a notional 36% of the fund.
Foreign equities were higher in October with NWM Global Equity up 1.7% versus +1.3% for the MSCI All World Index and +3.1% for the S&P 500 (all in CAD). Of our external managers, Cundill and Templeton Smaller Company were down 1.0% and 1.5% respectively while Carnegie, Edgepoint, and BMO Asia Growth and income were up 4.1%, 3.8% and 2.0%.
NWM U.S. Tactical High Income returned +0.8% in USD (approx. +1.5% in CAD) and is approximately 52% invested in U.S. equities, against which 76% has call options written.
New positions were added in Republic Services, Waste Management, and U.S. Silica. Presently, 24% of the fund is in high yield bonds, and 24% in held in the PIMCO USD Monthly Income Fund. The pool has also written put options on a notional 44% of the fund.
The REIT market was stronger in October, with NWM Real Estate up 1.7%. As was NWM Alternative Strategies, up 0.8% for the month.
Altegris funds Winton, Millennium, and Hayman were up 4.7%, 0.3%, and 0.1% respectively, while Brevan Howard was down 0.1%. SW8 was down 0.6% while RP was down 0.1%.
NWM Precious Metals was down 14.2% with gold bullion down only 2.4% during the month.
October In Review
It was a wild ride for capital markets in October.
Already headed lower, by the middle of the month Canadian equities were down more than 7%. In the second half of the month, however, traders quickly reversed course leaving the S&P/TSX down only 2% by All Hallows’ Eve.
It was trick, and then treat.
For the U.S., the recovery was even more dramatic. Despite being down almost 5.5% by mid-month, the S&P 500 ended the month with a gain of over 3% in Canadian dollar terms, and has subsequently gone on to hit new all-time highs in early November.
Historically, November, December, and January have been very kind to U.S. equity investors.
It was much the same story in global markets, with the MSCI up 1.3% for the month. Only Europe was in negative territory with the STOXX Europe 600 down 1.9% in Canadian dollar terms. The Nikkei 225 was also marginally lower, but only because of weakness in the Yen.
The equity exchanges were not the only markets experiencing a wild ride in October. Bond yields, oil, and gold all gapped lower, but unlike equities, oil and gold did not recover by month’s end, and appear to be heading even lower.
Why the quick reversal in equity markets? Good question.
We are still trying to figure out why prices headed lower in the first place. Not that a correction was unexpected. With over three years and counting since the last 10% correction, most believed the market was overdue for a little volatility, and yet surprised when it happened.
Started in September 2012 with $40 billion a month of mortgage bond purchases and expanded by $45 billion a month in Treasury bond purchases, the Fed has been gradually winding down the $85 billion a month program since January, and as expected, made their final $15 billion purchase in October.
The Fed still has $4.5 trillion of securities on their balance sheet, however, and plan to maintain this level for the foreseeable future. It is debatable that the end of QE caused the market to sell off because to conclude this, one has to first believe that QE has had a positive impact on the economy.
While it is true the Bears were wrong in fearing QE would lead to rampant inflation and kill the dollar, strong economic growth has been just as elusive.
The U.S. created 2.2 million jobs in the 12 months before the Fed launched the latest QE program and 2.6 million over the past 12 months with QE. The real question on trader’s minds isn’t so much when QE will end, but what the end of QE might mean for the timing of when the Federal Reserve will start raising interest rates.
Most feel the middle of next year is the likely target date, but the brief market correction in October pushed that back to later in the year.
But it’s not just market volatility that is prompting traders to questions the Fed’s commitment to higher rates.
While economic growth may be improving in the U.S., it is deteriorating everywhere else.
The IMF recently cut its global growth rate and pegged the risk of a recession in the Eurozone in the next 12 months at nearly 40%. With slow growth comes low inflation and a greater chance of deflation.
No one wants to become the next Japan, which has suffered through a deflationary funk lasting several decades. Even with the brighter U.S. economic outlook, American policy makers are concerned about the falling inflation rate.
And if they are not worried about falling inflation, then maybe the soaring U.S. dollar will pique their interest.
While the U.S. has been moving towards a tighter monetary policy, most of the world is still in easing mode.
The Bank of Korea cut interest rates in October while the Czech Republic, Sweden, and Israel all joined the U.S., Eurozone, U.K., and Switzerland in the zero interest rate club.
Japan actually one upped everyone one in late October by super sizing their monthly QE program to an annual target of ¥80 trillion (about $730 billion) from ¥60-70 trillion previously.
In addition, the Government Pension Fund announced plans to diversify the $1.2 trillion fund away from Japanese government bonds and buy Japanese and foreign stocks.
And who can blame them?
Yes, Japan wants to drive inflation to 2%, but a cheaper Yen is all part of the plan. Already the Yen is down about 10% since the end of June and depreciated 6% in the last half of October alone, and the Bank of Japan is hungry for more.
The U.S. can probably tolerate a weaker Yen for a period of time. Less dependent on trade and with an economy on the mend, a stronger Yen is not headline material.
But this is not the case for China. With a currency that is loosely pegged against the U.S. dollar and an economy that is still geared towards exports, China will be less tolerant.
Third quarter GDP grew 7.3%, meaning China is growing at its slowest pace in five years and is likely to miss its annual growth target for the first time since 1998.
In the past, China has indicated it needs at least 7.2% growth to create the 10 million new jobs needed to keep up with demographic trends.
Along with China, put the Eurozone in the not-so-tolerant camp.
The ECB desperately wants to depreciate the Euro and ECB President Mario Draghi recently expressed confidence that the European Central Bank will be able to expand its balance sheet back (meaning QE) to 2012 levels, or an increase of upwards of €1 trillion.
Time is running out for Europe. Its citizens are growing wary of austerity and high unemployment. If current governments are not able to solve the problem, there are more radical alternatives waiting in the wings.
Case in point, the most popular party in Greece right now is the Syriza party. If elections were held today, 40 year old former student Communist Alexis Tsipras, a person described by Der Spiegel magazine in 2012 as the most dangerous man in Europe (and I thought it was Barcelona striker Lionel Messi – or perhaps the biter, Luis Suarez!) would become Prime Minister.
But it’s not just Greece where radical political parties are gaining favor. In France, Marine Le Pen’s National Front is challenging current President Francois Hollande while in Italy, Beppe Grillo and the Five Star Movement is gaining support.
Even in Spain, Pablo Iglesias and the Podemos party is rising in the polls. With inflation continuing to trend lower, many fear Europe could be the next Japan. Others suggest Europe could only wish as much!
So what does this mean for the markets?
This is good for stocks. Also, November through December is usually a favorable time of year for equity returns, and it is even more this year because U.S. mid-term elections were just held.
Regardless of the outcome, the stock market has historically done well in the 3, 6, and 12 months after the mid–term elections.
Since 1942, in fact, the S&P 500 has risen 15.6% on average over the next 12 month time period post-mid-term elections, and has been positive a perfect 18 out of 18 times. Even better, since 1945 a unified congress has historically resulted in higher annual returns for the S&P 500 than a split congress.
The Republican party taking control of both houses in early November has thus set the stage for higher stock prices. The best scenario would be a Republican becoming President in 2016, which would result in a unified government and historically, the best environment for stocks.
Of course 2016 is a long way off. Plenty of time for voters to change their views a few times.
Investors are likely to be watching what the Fed does more than Washington, however. As discussed above, we don’t see interest rates moving meaningfully higher in the near term.
With the U.S. economy continuing to recover, corporate earnings should continue to move higher.
Low interest rates, an improving economy, and higher corporate earnings, should translate into good equity markets.
Expect corrections along the way, however.
While the Ebola outbreak appears to be under control and North Korean leader Kim Jung-Un has finally re-appeared unscathed, there are plenty of other things that could derail the market.
Expect volatility to pick up and the sudden sell off and recovery seen in October to become more common.
Timing the market is tough. According to JP Morgan, the S&P 500 has delivered an annualized return of about 9.2% over the past 10 years (as of December 31, 2013). But be out of the market for the 10 best days, and returns drop to only 5.4%.
It’s hard to stay calm when the market drops sharply, but historically some of the largest daily percentage gains in the market have happened right after the worst.
Average investor returns tend to lag that of individual asset class returns because emotional investors generally buy and sell at the wrong time.
As Richard Bernstein points out, most investors would have been better off buying and holding any single asset class, other than Asian emerging equities or Japanese equities, over the past 20 years rather than trade in and out of the various assets classes that they did.
The return of the “average investor” over the past 20 years is not very impressive. Of course, we believe a highly diversified portfolio is an investor’s best defense against emotional reactions in an uncertain world.
We like equities, but only as part of a diversified portfolio.
The U.S. Economy
Given the recent strength in the U.S. dollar, future GDP might suffer from a reversal in the trade deficit as exports growth slows. In fact, we wouldn’t be surprised if Q3 GDP isn’t revised lower, given the recently reported September trade deficit came in worse than expected.
Looking forward, there are a number of positive signs that indicate economic growth will continue to accelerate.
Employment, which we will discuss in more detail below, continues to grow, manufacturing is strong, spare capacity is gradually being put back online, and interest rates remain accommodative.
On the negative side, weak foreign demand (we’re looking at you Eurozone) and a strong dollar will act as a head wind to economic growth.
The U.S. isn’t as dependent on trade as other developed nations, with exports representing only a 14% share of GDP versus 51% for Germany and 26% for China. Global “weak link” Europe accounts for only 15% of U.S. foreign trade.
Regardless, a soaring U.S. dollar is going to hurt.
The wild card for U.S. growth is oil.
With crude oil down almost 30% since the end of June, the benefit to consumers would appear to be a major plus for a U.S. economy that is comprised nearly 70% of consumer spending.
It’s not all good news, however, since America is simultaneously the world’s largest consumer, importer, and producer of oil.
According to the Commerce Department, oil and gas capital expenditures accounted for 0.8% of total U.S. GDP in 2013 while Goldman Sachs estimates the energy sector alone accounts for almost a quarter of S&P 500 cap ex and R&D spending.
More importantly, the oil and gas sector employed 213,500 well paid workers last year. No burger flippers here.
Goldman believes the positive impact on consumer spending could be roughly canceled out by the negative impact to capital spending. Of course, certain sectors and stocks will fare better than others.
In fact, the U.S. has not created less than 200,000 in a month since January, a nine month record dating back to 1995.
The unemployment rate ticked down one tenth of a percent to 5.8% and is moving closer and closer to the Federal Reserve’s full employment target of around 5.5%. The short term unemployment rate moved down to 3.9%, the lowest it’s been since 2007.
Surely these bullish numbers will compel the Federal Reserve to increase interest rates, right? After all, momentum in the labour markets is presently much greater than in 2005, and the Fed Funds rate then was 5%!
What is the Fed waiting for?
Well, wage growth for one.
Hourly wages actually moved slightly lower in October and have been stuck around the 2% level for months, barely above inflation. The Federal Reserve is concerned the lack of wage growth is an indication there is still slack in the labour force.
Of course wage growth is a lagging indicator, and there is some indication that wages could be set to move higher.
The Labor Department’s employment cost index rose 0.7% in Q3 after a similar rise in Q2, the first consecutive quarterly gains of at least 0.7% since 2008.
In addition, the Commerce Department observed total wage and salary income in Q3 posted an annual growth rate of 5%.
One would think a tighter labour market will eventually result in higher wage inflation, but the Federal Reserve is being extra careful. Once it finally does appear, expect the market to panic over fears of inflation.
That’s how higher volatility works, my friends.
Inflation was basically unchanged in September, though news stories and commentary about declining inflation and fears of deflation continue to ratchet higher.
With oil and gasoline prices moving lower, there is the risk inflation moves even lower over the coming months, ratcheting up fears of deflation even more.
Consumer confidence numbers were strong in October. Lower gasoline prices and a strong job market are likely catalysts.
Retail sales and consumer spending were unexpectedly weak in September.
Weaker auto sales were expected, given recent strength and lower gasoline prices lowered the dollar value of retail spending, but core retail sales were still weak.
It’s just one month, so we won’t get too excited, especially given the strong consumer confidence numbers in September.
Along with a rebounding labour market, lower energy prices will put more money in consumer pockets.
Deutsche Bank is estimating lower gasoline prices. Every one cent change in the price of gas reduces household energy expenditure by about $1 billion.
In total, this could add more than $40 billion to consumer cash flow, or the equivalent of over a quarter of a percent of annualized GDP growth.
September existing home sales were up a little from the previous month, but are still down year over year.
One of the reasons home sales have slowed is investors have pulled away from the market.
Last September, investors accounted for 19% of existing home sales compared to just 14% this September.
Higher prices and less product available for sale are cited as the main reasons for waning investor interest.
Also acting as a head wind is demand from first time buyers. At only 33%, the share of existing home sales coming from first time buyers is close to a 30 year low. Since 1981, first time buyers have typically comprised about 40% of home sales.
The absence of first time buyers in the housing market is also impacting the market for new homes.
While sales were decent in September, builders have been targeting higher end buyers and have made the decision to sell fewer homes in exchange for higher prices.
The spread between the median new home price and that of an existing home has exceeded $70,000 during the economic recovery – the widest spread since this figure began being tracked in 1968.
While new home prices were lower in September, prices for new homes have generally risen faster than existing homes as builders have concentrated on bigger, more luxurious homes.
Lower mortgage rates and an easing in mortgage lending rules by regulators should help both new and existing home buyers in the coming months.
It’s slow going, but we still believe the housing market recovery is on track.
The U.S. trade deficit widened in September as exports fell to a five month low, declining 1.5% from the previous month.
Weakness was seen in industrial supplies and autos with demand from both Europe and China declining.
Imports from China hit an all-time high and were up 13%, though a majority of the increase was due to iPhone 6 shipments.
The larger than expected trade deficit will likely result in a downward revision in Q3 GDP growth, possibly to 3% from 3.5%.
The Canadian Economy
In August, Canadian GDP unexpectedly contracted 0.1% as slower activity in auto production and oil and gas extraction crimped growth.
The lower activity is likely temporary as auto manufacturers took more summer related downtime and scheduled maintenance impacted the oil and gas industry.
Looking forward, Bank of Canada Governor Stephen Poloz recently forecast lower oil prices could decrease GDP growth by a quarter of a percent next year.
Offsetting the impact of lower oil prices is the strengthening U.S. economy and the potential for Canadian merchandise export growth to more than make up the difference – especially given the recent decline in the Canadian dollar.
While oil is important to Canada’s economy, profits from the energy sector represent only 3% of GDP. By comparison, Norway derives 11% of its GDP from profits earned off North Sea oil.
Quality was high, as 26,500 of the new positions were full time and most came from the private sector.
Wage growth was a little light, but still a very good month.
Inflation remains near levels targeted by the Bank of Canada with no near term pressures to the upside.
A broad based decline in retail spending was aided by lower gasoline prices.
This is the second consecutive month retail spending has contracted. A welcome break, given Canada’s high consumer debt levels.
Existing home sales and prices remain firm, though Toronto, Calgary, and Vancouver drove most of the strength.
We still expect the housing market to moderate over the coming months, especially as interest rates start to trend higher — but we have been saying this for months.
The housing market continues to defy gravity, and this is a concern for the Bank of Canada and probably the biggest reason a cut in interest rates is very unlikely.
Besides, with the Canadian dollar falling against the greenback, one of the biggest benefits of lower interest rates is already working in Canada’s favor.
Canada’s balance of trade moved back into a surplus position in September, and a weaker dollar should help in the coming months. This is good news for GDP growth.
Overall, a stronger U.S. economy and weaker dollar are good for the Canadian economy.
Weaker oil prices and an eventual slowdown in the housing sector are risks and likely means Canada underperforms against the U.S. economy.
Still, expect stable, but low growth.