Market Commentary: A Kumbaya Moment for Investors


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were up 1.6% in the month of April.  The Nicola Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of Nicola Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

The Nicola Bond Fund returned +0.7% in April, and is +3.0% year-to-date. Although Canadian interest rates stopped their steady decline, positive economic data continued to tighten investment grade credit spreads. The Nicola Bond Fund’s largest performance contributor in April was credit strategies fund Arrow East Coast Investment Grade Fund II which gained +1.7%. The Nicola Bond Fund currently has a net yield of 2.7% and low 2.2 year duration.

The Nicola High Yield Bond Fund returned +1.1% in April, and is +3.5% year-to-date. The high yield bond market continued its 2019 gains in April, extended technically by positive fund inflows into an asset class that continues to shrink in net bond issuance and size. The BoAML U.S. High Yield Index yield started the year at 8.0% and is presently down to 6.2%, a yield matching last year’s low reached in June. The Nicola High Yield Bond Fund is defensively positioned, carrying a net 4.5% yield, protecting against market selloffs while remaining nimble enough to reposition into higher yields during market volatility.

The Nicola Global Bond Fund was up 1.0% for the month. In emerging markets, Mexican, Argentinean, and Russian exposure drove returns higher. Domestically, investment grade credit spreads tightened about 0.1% while high yield spreads tightened 0.3%, providing a tail wind for our credit exposure.  Low duration overall helped mitigate losses from interest rate exposure as core interest rates reversed course and drifted higher during the month.

The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.4% and +0.5% respectively last month. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.0% for the Nicola Primary Mortgage Fund and 5.5% for the Nicola Balanced Mortgage Fund.  The Nicola Primary Mortgage Fund had 22.6% cash at month end, while the Nicola Balanced Mortgage Fund had 13.1%.

The Nicola Preferred Share Fund returned 0.4% for the month while the BMO Laddered Preferred Share Index ETF returned 0.5%.  Strong inflows into ETF’s help support returns during the month as investors focused on buying rate resets versus perpetual preferred shares. April inflows marked the second straight month of positive flows, hopefully forming a trend with sentiment amongst retail investors turning more positive on the space. There was one new issue during the month from Bank of Montreal. The bank sold $350 million with a 5.1% coupon and a 3.51% spread. We participated in the deal which was well met by investors and subsequently ended the month up $0.38 or up 1.5%.

The S&P/TSX was +3.2% while the Nicola Canadian Equity Income Fund was +4.2%. Consumer Discretionary, Materials and Energy were the top three contributing sectors. The top detracting sectors were Industrials, Information Technology and Health Care. We added Brookfield Property Partners, Allied Properties REIT and Interrent REIT. We sold Hudson’s Bay and Sleep Country. Top contributors to performance were Spin Master, Aritzia, and Dollarama. Top detractors were Heroux-Devtek, Park Lawn, and Canwel Building Materials.

The Nicola Canadian Tactical High Income Fund returned +3.1% vs the S&P/TSX’s +3.2% return.  The Fund’s relative underperformance was mainly due to being underweight Financials.  As the market continued to move higher, market participants became more complacent and less concerned about  risk as shown by the decline in Canadian option volatility index (-11.3% for the month).  The Nicola Canadian Tactical High Income Fund was still able to earn double-digit Put option premiums and high single-digit downside protection on select names.  The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 63.5% (69% prior) and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market.  CI Financial Corporation was a new name added; we also added to our existing Bank of Nova Scotia and Guardian Capital positions.

The Nicola U.S. Equity Income Fund returned 3.6% in April, while the S&P500 returned 4.1%.  Performance from Banks, namely JPM and BAC contributed to performance, while detractors included EA and Hormel Foods.  Not owning Facebook also hurt relative performance.  In terms of new names, we added Seagate Technology, a maker of hard disc drives whose business to datacenters is growing robustly.  We sold our shares in Dow Inc, a commodity petrochemical company.  We received Dow shares as part of a spin-out from DowDuPont, which we continue to own.

The Nicola U.S. Tactical High Income Fund returned +3.3% vs +4% for S&P 500.  The Nicola U.S. Tactical High Income Fund’s relative underperformance was mostly due to being underweight Info Tech & Communication Service sector. Option volatility decreased 2.1% during the month to its lowest level since October 2018.  Despite the low volatility in the broader markets, we were still able to generate high single-digit annualized premiums.   The Nicola U.S. Tactical High Income Fund’s delta-adjusted equity decreased from 50% to 35.6%.  New names added to the portfolio were a hard drive maker (Seagate Technology) and two industrial automation companies (Rockwell Automation & Emerson Electric).  The portfolio remains defensively positioned with a lower valuation multiple, and higher free-cash-flow and lower leverage relatively to the S&P 500.

The Nicola Global Equity Fund returned +2.7% vs +3.8% for the MSCI ACWI (all in CDN$).   The Nicola Global Equity Fund underperformed the benchmark due to country selection (underweight U.S.).  Sector contribution was mixed as the Nicola Global Equity Fund’s benefited from being overweight Financials and Consumer Discretionary but was underweight technology.  Overall, large-cap and growth stocks outperformed small-cap and value stocks. Performance of our managers in descending order was Nicola EAFE Quant +4.2%, C Worldwide +4.1%, Lazard +3.8%, Edgepoint +3.3%, BMO Asian Growth & Income +1.5%, and ValueInvest +0.77%.

The Nicola Global Real Estate Fund was -0.2% for the month of April vs. the iShares (XRE) -3.3%. Publicly traded REITs make up 28% of the fund. The Canadian 10 year bond yields moved up in the month of April from 1.62% to 1.71% which caused some volatility in the REIT sector. Overall we think that conditions are still good. We are focused on reasonably valued REITs with superior per-unit growth profiles. In particular, we focus on same-property NAVPU/NOI/AFFOPU growth, declining leverage, major-market presence, and cash flow durability. In our view, the most attractive sectors in terms of fundamentals are Apartments and Industrial and have tilted the portfolio towards those areas.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of April 30th, March performance for the Nicola Canadian Real Estate Limited Partnership was +2.5%, Nicola U.S. Real Estate Limited Partnership +1.1%, and Nicola Value Add Limited Partnership 1.4%.

The Nicola Alternative Strategies Fund returned +1.4% in April (these are estimates and can’t be confirmed until later in the month).  Currency contributed 0.2% to returns as the Canadian dollar weakened through the month. In local currency terms, Winton returned +2.1%, Millennium +0.4%, Apollo Offshore Credit Strategies Fund Ltd +0.8%,Verition International Multi-Strategy Fund Ltd +2.6%, Renaissance Institutional Diversified Global Equities Fund -2.3%, RPIA Debt Opportunities +1.2%, and Polar Multi-Strategy Fund +1.1% for the month.  We are in the process of redeeming our position in Apollo Offshore Credit Strategies to better align our mandate of maintaining a return profile that is agnostic to market conditions.

The Apollo fund has the ability to be opportunistic including the ability to have a net long exposure to overall credit. We are still constructive on selective credit exposure and still consider Apollo a best of breed manager; however, Apollo Offshore Credit Strategies is better suited for our Nicola High Yield Bond Fund as a defensive high yield position.  The strong returns in the Alternative Strategies fund were supported by Verition International Multi-Strategy fund which benefitted by merger arbitrage as well as event driven positions (both appraisal rights and traditional merger arbitrage). Appraisals rights is a strategy that Verition employs that focuses on the right of a shareholder to have an independent valuator determine fair value of a stock price when a company is being purchased. The policy prevents majority shareholders from purchasing remaining shares from minority shareholders at a significant discount to market price.

The Nicola Precious Metals Fund returned -5.3% for the month while underlying gold stocks in the S&P/TSX Composite index returned -5.4% and gold bullion was -0.4% in Canadian dollar terms. Generally, gold equities and gold bullion should move in tandem. We believe the high level of divergence realized during the month between bullion and equities should revert in time. In terms of the overall bullion price, the World Bank Group came out with its commodity outlook report during the month. The World Bank sees gold prices rising over 3% in both 2019 and 2020 by growing investor demand and central bank buying.

 

April in Review

Global equity markets continued to move higher in April, with only Chinese stocks ending the month in negative territory.  The S&P/TSX gained 3.2% and the S&P 500 increased 4.0% (in U.S. dollar terms) while the Shanghai Composite slipped 0.4%.  Year to date, it’s been a kumbaya moment for investors with most asset classes trading higher.  According to Deutsche Bank, of the 70 financial asset classes they track, nearly 90% posted positive returns, a remarkable turnaround from last year when 87% of asset classes ended the year in the red.  On average, 70% of assets classes have historically delivered positive returns.  For the S&P 500, year to date returns of over 18% at the end of April were the highest since 1987.

 

S&P 500 closed above its previous all-time high

The S&P 500, in fact closed above its previous all-time high on April 23 for the first time in 145 trading days, erasing its nearly 20% pre-Christmas drop in a mere 80 days.  Impressive, but not unprecedented, with 1982’s 27% correction recouped in only 58 days and 1998’s 22%  swoon replenished after 32 trading days. Canadian stocks were equally impressive, taking 193 days to close above its previous high (July 12, 2018) but requiring only 79 days to recover their Christmas Eve losses.

On the surface, a sense of complacency appears to have returned to the market as volatility has retreated to levels seen last summer and the technology sector has resumed its leadership role in terms of market returns.

Beneath the surface, however, investors remain cautious post the late December correction.  Fund flows into equities have been mixed at best with the companies themselves being the biggest buyers of their own stock rather than institutions and households.

While the growth oriented technology sector is the top performing sector year to date, the defensive utility sector is still the top performing sector since the previous market top in September of last year.  Also, while stock prices have bounced, bond yields have not.  The strong move in equity markets year to date would imply the path forward for stocks is higher, but the underlying market action indicates the path is less straightforward.  The answer, we believe, resides with the state of the real economy and the action, or inaction, of the Federal Reserve.  Let’s look at both shall we.

 

Nearly 50% of money managers believe the next recession will arrive before the end of next year.

Investors are fixated on the business cycle and timing the next recession, and the consensus is we have less than a couple of years left.  According to Barron’s recent Big Money poll, nearly 50% of professional money managers believe the next recession will arrive before the end of next year.

Only 20% see the U.S. economy being able to make it past 2021 without suffering a contraction. According to a survey of investors and business executives by Corbin Advisors, however, while the consensus might believe the cycle has already peaked, or will peak this year, sentiment has improved since December.  Investors still believe the end of the current cycle is in sight, but they now think it will take a bit longer to get there.   This is a good thing.

 

Investors are concerned corporate earnings have peaked and are headed lower. 

According to FactSet, earning per share for U.S. equities have increased 80% since the beginning of 2008, leaving U.S. corporate profits as a percent of GDP near record levels.  Companies have started “talking down” forecast on earnings calls in anticipation of weaker results and have been using words like “optimistic” less frequently.

While it is true earnings growth is unlikely to match the torrid pace of the past couple years, investors need to step back and take a longer perspective.  Profit margins are high, but there are secular reasons to justify present levels.  Also, while first quarter earnings may in fact contract, analysts believe results should improve later in the year.

According to the Barron’s Big Money poll, an overwhelming percentage of professional investors believe earning growth will be positive this year and next.  Also, it’s normal for forecasts to be revised higher as the year progresses as companies like to lowball the street, and it looks like this year will be no different as first quarter results appear to be coming in greater than expected.  This is also a good thing.

 

The yield curve’s abnormal inversions

One of the indicators investors have been fixated on in order to determine where in the business cycle we are and how close a recession may be is the yield curve. A normal yield curve is upward sloping, with shorter term treasury bonds yielding less than longer term bonds.  Last December the short end of the yield curve inverted, with two year Treasury’s yielding more than five year Treasury’s.  It wasn’t a lot, but it was the first time this had happened since before the great recession.  Then in March, the ten year versus three month yield curve also inverted.  The inversion was brief and had disappeared by the end of the month, but it was a negative sign given the near perfect record this recession indicator has historically had.  By the end of April, not only had the ten year versus three month yield curve steepened, but the spread between the five year and two year treasury became positive again such that this part of the yield curve was again upwardly sloping.  Once more, this is a good thing.

What is less of a good thing is why the yield curve has steepened.  The market has become convinced the Federal Reserve is going to cut rates, once this year, and once in 2020.  Not satisfied with stronger than expected first quarter GDP growth and a surging stock market,  President Trump recently floated the idea of a 1% cut in rates (four 25 basis point cuts), but then he is running for re-election in 2020.

In fairness to Trump, an abrupt change in course during a tightening cycle is not without precedent.  In both 1995 and 1998, the Federal Reserve lowered rates as insurance against a potential recession, even though economic numbers at the time were pretty good.  In 1998, it was events abroad, namely the Russian debt crisis and the Asian Financial crisis, the central bank was trying to insulate the U.S. economy from.  In 1995, it was moderating price pressures (lower inflation).  These cuts helped extend the economic expansion, but also lead to asset bubbles and then eventually the dot com induced bear market.

 

Between foreign contagion and lower inflation, the market appears to believe inflation is the bigger concern. 

Despite a stronger economy and an economic expansion now in its tenth year, inflation has failed to consistently hit the Federal Reserve’s 2% target.   This presents a problem for the Fed for two reasons.  First, there is the concern in the next recession that nominal rates won’t be high enough to allow the central bank enough ammunition to stimulate economic growth.  During the past seven recessions, the Fed has cut rates an average of more than 5%.  With nominal overnight rates currently only 2.25% to 2.50%, conventional monetary policy is limited.

Second, low inflation increases the risk of a deflationary spiral in the next recession, with consumers putting off purchases in hopes of buying at lower prices in the future.  We question whether this is really a threat in today’s world, but in order to provide readers full disclosure of the arguments being considered, we feel compelled to include it.

In order to better address these concerns, Chairman Powell and his colleagues at the Fed have discussed the possibility of using different monetary policy models to help adjust to our current low inflation world. It is unlikely Powell will agree to any radical changes, but letting inflation run a little hotter in order to compensate for the fact it has been below 2% for an extended period would appear to be under active consideration.

Chairman Powell and the Federal Reserve are in a tight spot.  They want stronger inflation so higher nominal interest rates will give them more room to cut rates in the future, but in order to get higher rates they actually have to delay raising rates, the very thing they want to accomplish.

Unlike some analysts and magazine covers, the Fed isn’t worried about inflation and certainly doesn’t believe inflation is dead.  They believe the recent weakness is transitory and inflation will re-accelerate later in the year.  According to the Barron’s Big Money poll, most institutional investors would agree, with over three quarters believing inflation will range between 1.5% and 2% over the next twelve months.  According to the Minnesota Fed, investors believe inflation will range between 1% and 3% over the next five years.

Are they right?  Core inflation has recently been trending lower and is projected to remain low until later in the year.  Even worse, research indicates inflation might be even lower if on-line prices were used for the government’s consumer price index baskets instead of surveys.  Inflation calculations, however, can be fairly complex and subjective in how they are calculated.    According to the Atlanta Fed Core Sticky CPI Index, for example, inflationary pressures have remained consistently in excess of 2% over the past year.  Anecdotally, inflation doesn’t feel dangerously low to us.

Wage growth will be a key variable for determining whether inflation remains low.  Since the unemployment rate has fallen below 5% (3.6% in April, lowest since December 1969), wage growth has increased, but not at the same pace as past economic recoveries.  With the gap between the unemployment rate and what is considered full employment (the natural rate of unemployment) continuing to widen, many expect wage growth to accelerate.  Already, more companies are mentioning labor costs on earnings conference calls and the number of small businesses citing cost of labour as their single most important problem has been increasing.  For the Fed, the key remains around inflationary expectations.

 

Consumers believe inflation is anchored around 2% and set their expectations accordingly. 

If the Fed sees expectations start to move meaningfully lower, they will be compelled to act and the market could be right about rate cuts. On the other hand, wage growth will be a key component in gauging inflationary expectations and higher wages would provide a green light for the Fed to continue raising rates.  Because markets are discounting the next move by the Fed to be a cut in rates, a move by the Fed to resume raising interest rates would be disappointing, and no one likes a disappointed market.

 

The trade war is back on investor’s radars

The market was also discounting a trade deal between the U.S. and China, which in early May is in the process of disappointing markets as the trade war is back on to the investor’s radar.  Based on comments by both U.S. and Chinese negotiators, the market believed a trade deal was imminent.  RBC data, in fact, showed 80% of companies didn’t even mention the trade war on first quarter earnings calls.  There were always concerns certain issues were going to be harder to resolve than others, but at least some of the strong years to date gains in stocks were due to the diminished risk of a trade war.

On Sunday May 5th, however, President Trump expectantly tweeted displeasure at the process being made, threatening increased tariffs by the end of the week.  UBS believes U.S. stocks could fall 15% if talks break down.  Chinese equities are already down over 5% in the first two trading days in May.

It’s too bad, because global economic growth looked to be stabilizing, in China as well as in the U.S.  After Trump’s tariff tweets, even the five year versus two year yield curve inverted once again as bond yields headed lower along with equities.

If Trump does increase tariffs (which he did), taking the trade war to a new level, the Federal Reserve just might feel compelled to cut interest rates.  It could be final posturing before a deal is signed, or it could be signs both sides are taking a harder line.  We believe monetary policy (higher overnight interest rates) and the trade war were behind last September’s sell off.

Between the two, the trade war might have provided the greater headline risk, but tighter monetary policy was the real threat to the markets in our opinion.  As monetary policy risk ratchets down and trade war risk escalates, his theory looks like it will be put to the test.  To be continued next month.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Returns are quoted net of fund/LP expenses but before Nicola Wealth portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. For a complete listing of Nicola Wealth Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg. Effective January 1, 2019 all funds branded NWM were changed to the fund family name Nicola. Effective January 1, 2019 Nicola Global Real Estate Fund, Nicola Canadian Real Estate LP, Nicola U.S. Real Estate LP, and Nicola Value Add LP adopted new mandates and changed names from NWM Real Estate Fund, SPIRE Real Estate LP, SPIRE US LP, SPIRE Value Add LP.