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Are Markets Prepared to Walk Off a Cliff?

 Highlights This Month

Read this month’s commentary in PDF format

The NWM Portfolio

It was, again, a mixed month in November.

Bonds had another solid month with the NWM Bond Fund up 0.2%.  Short rates were effectively unchanged with two-year Canada’s going from 1.07% at the end of October to 1.06% at the end of November.  Ten-year Canada’s, however, rallied almost 10 basis points, with yields declining from 1.78% to 1.70%.

High yield bonds took a bit of a breather in November, with the NWM High Yield Bond Fund gaining a mere 0.2%.  High yield bonds have been on quite a tear this year, up over 9%, so we’ll excuse them for taking a month off.

Mortgages continued to provide steady returns in November, with the NWM Primary Mortgage Fund gaining 0.4% and NWM Balanced Mortgage Fund increasing 0.5%.  Going forward yields are unchanged from last month, 4.2% for the Primary Mortgage and 7.0% for the Balanced Mortgage.

Preferred shares were up in November, though just barely, with the NWM Preferred Share Fund gaining 0.1%.  We are selectively trading out of perpetual issues trading at large premiums that we feel are at risk of being redeemed.  We also continue to take advantage of the new issue market in order to deploy cash.

Canadian equities were lower in November with the S&P/TSX down 1.3% (total return, including dividends), but the NWM Strategic Income Fund managed to keep its head above water, returning a positive 0.5%.

Being under weight in gold helped, but we also expect to out-perform in a weaker market.  We continue to run the fund a little more aggressively.  The cash weighting is at an all-time low of 5.9%.  The yield is also a little lower at an estimated 5.9% as we ease up a bit on the covered call writing.

We continue to find interesting names and are now at a stage where we will need to sell to trim or sell a position if we want to add a new name in the portfolio.

Foreign equities were mainly higher in November with most of our external funds posting positive returns during the month.  The NWM Global Equity Fund gained 1.2% while the MSCI All World Index was up 0.7%.

Real estate was weaker for the second month in a row in November with the NWM Real Estate Fund down 0.8%; however, recent takeover activity has put a bid under the sector in early December.


By Rob Edel, CFA

Markets were moderately weaker in November as the S&P/TSX lost 1.3% while the S&P 500 and Dow retreated 0.1% and 0.8% respectively.

It could have been a lot worse, however, as a rally near month-end kept losses at minimal levels.  By mid-November, in fact, the NASDAQ was down over 10% from recent highs, but a second half turnaround enabled it to finish the month up 1.4%.

The NASDAQ is dominated by tech stocks, which are considered good barometers of the global economy, given a large percentage of their sales go to customers outside of North America. With the recession in Europe and slowdown in China, any company with exposure to these regions was at risk of missing earning estimates and punished by the market.

Too bad: technology companies tend to have good organic growth, growing dividends, and reasonable valuations.  In short, everything we look for in a company.

MMC-2012-11-On the Downslope

Another overhang for the market was, and continues to be, the uncertain U.S. political landscape and the possibility of the U.S. falling off the Fiscal Cliff.

Companies are reluctant to hire workers and invest capital without knowing how much tax they are going to have to pay in the future.  In the end, third quarter earnings came in better than expected and, with the help of some decent domestic economic numbers, the market moved higher near the end of the month.

Revenue growth, however, was weak, falling for the first time since 2009 and indicating companies were seeing less activity.   A recent Wall Street Journal review found that half of the 40 largest publically traded companies in the U.S. have plans to reduce capital spending this year or next.

When asked why, executives cited easing demand and increased uncertainty, especially around the U.S. elections and federal budget policies. It is almost becoming a self-fulfilling prophecy; fears that falling off the cliff could result in a recession are making companies and consumers reluctant to spend and creating a slowdown in the economy.

Even if a deal is made before the end of the year to prevent the U.S. from falling off the Fiscal Cliff, some damage to the U.S. economy has already occurred.

MMC-2012-11-Cooling off Soft sell

So how are the Fiscal Cliff negotiations going?  Slow may be an optimistic description.  It’s hard to tell what’s real and what’s just political bargaining, but it appears Obama and the Democrats are playing hard ball.

Increasingly, there is a perception that the Democrats are fine to fall off the cliff.  They really view the cliff as more of a steep decline and believe there will be plenty of time in the New Year to negotiate before tax increases and spending cuts start to impact the economy.

By letting taxes increase for everyone at the end of the year, Democrats could start from a clean slate and push for tax cuts just for the middle class, which is what they want now.  It would be very hard for the Republicans to vote against this.

Even better, a recent poll conducted by the Pew Research Center found 53% of Americans would blame the Republicans if no deal is reached versus only 29% blaming Obama and the Democrats.

So far, Obama is offering a deal which would include $1.6-billion in increased taxes over ten years with higher tax rates for those making over $200,000.  In addition, he wants $150-billion in new public works programs and a permanent increase in the debt ceiling.

In return, Obama might concede $400-billion in entitlement spending cuts, but is giving no clues as to the details.  Presumably they would be worked out at a later date, kicking the can down the road if you will.   This is clearly a deal the Republicans cannot accept.

In the Republicans’ opening bid, they indicated they were willing to accept higher tax revenue in exchange for entitlement spending cuts, but drew a line in the sand in regards to higher tax rates – for anyone.

It now looks very likely they will have to abandon the rich and agree to a higher marginal tax rate for those earning over $200,000, but they still want spending cuts in the form of entitlement spending reform.

The Republicans’ problem is they need a deal a lot more than the Democrats do, and Obama knows it.  We still think a deal gets done, but it’s by no means a done deal.

MMC-2012-11-More taxes

Normally, we would talk about Europe next, but we have decided this month to take a European holiday.

No, this doesn’t mean we are off to the Alps for a little break; we are just plain tired of writing about the EU.  After all, it’s the holiday season, time to be jolly and merry.  This is hard to do when discussing Europe.

Rest assured, The Eurozone will still be mired recession and clouded with uncertainly next month.  In its place, we plan to talk about Japan.

Frequently described by financial pundit John Mauldin as “a bug in search of a windshield,” Japan has, for the most part, escaped investor scrutiny and has largely been treated as a safe haven by investors looking to escape the sovereign debt problems of Europe and political dysfunction in the U.S.

MMC-2012-11-Still a Safe Haven

But is Japan a safe haven?  Japanese companies are caught between a domestic economy that hasn’t grown in years and an export market that is getting killed by the strong yen.

To make matters worse, they are having a territorial dispute with one of their largest trading partners, China.  Exports to China were down nearly 12% in October and 15% in November.

Even Chinese tourists are giving Japan the cold shoulder, with the Japanese National Tourist Organization reporting a 33% drop in Chinese tourism in October.  A high price to pay for what is described as five rocky islets whose only inhabitants are a herd of goats.

Ok, maybe there is some oil as well.

MMC-2012-11-Destination Tokyo

In the third quarter, Japanese GDP contracted for the second quarter in a row, shrinking 3.5%, the largest drop since March 2011 when Japan was rocked by a massive earthquake and tsunami.

That Japan is in recession is not a surprise.  This will be the fifth in the last two decades.  The fourth quarter isn’t looking any better with exports down 6.5% in October.  This is a slight improvement from September’s 10% drop, but the fifth month in a row of decline.

MMC-2012-11-Targeting Weakness

The Japanese government’s response to the current slowdown is the same as most developed nations: ratchet up monetary policy.

In late October, the Bank of Japan announced plans to increase its bond buying program from ¥80-trillion to ¥91-trillion after just increasing it by ¥10-trillion in September.  The program will complete at the end of next year and its goal is to get Japan out of the deflationary funk that has plagued the country since the early 1990’s.

Shinzo Abe, front runner to become Japan’s next Prime Minister in early December, is on record as calling on the Bank of Japan to pursue a program of unlimited bond buying in order to achieve a 2% inflation target.

He has also formulated a ¥2.4-trillion spending program and indicated he might delay current Prime Minister Noda’s sales tax increase.

This sounds great for economic growth, but what about the cost?  At about 220% of GDP, Japan has a lot of government debt.  To put this in perspective, The OECD estimates Italy’s debt to GDP will end 2012 at 128%.

Japan, in fact, has about the same amount of debt as the U.S., except its economy is half the size.  This isn’t a problem when you are able to borrow 10-year money at around 1%, but if you are going to target 2% inflation, higher interest rates are inevitable.

Historically, investors could point to Japan’s ability to fund its deficit internally (90% of Japanese government bond holders are domestic) and a healthy current account surplus (balance of trade plus net investment income) as reasons why Japan can get away with such high government debt levels.

In September, however, Japan reported a current account deficit for the first time in 30 years.  While the current account reverted back to surplus in October, the Japan Center for Economic Research argues that Japan could run a structural current account deficit as soon as 2017 if energy import prices remain high and nuclear power plants remain on the side lines.

If this happens, Japan will need to tap the international debt markets for funds, and you can bet they will charge more than 1% interest.  I know we would.

Why do we care?  Well, as the world’s third largest economy, Japan would truly be too big to bail out.  Also, if Japan is no longer viewed as a safe haven, how much time do we have before the U.S. falls out of favour?

Not a very merry thought.  Maybe we shouldn’t have taken that European vacation after all.

MMC-2012-11-The benefits of Deflation

The U.S. Economy

MMC-2012-11-Economic Growth-Table-US

Third quarter GDP growth was revised higher at the end of November, as strong consumer spending earlier in the year motivated companies to increase inventories in order to satisfy demand.

The sustainability of the increase in GDP is in question, however, as consumer spending has recently slackened.  Consumer spending, while still the major driver of GDP growth, was revised lower in Q3 and appears to be slowing as we approach the end of the year.

If consumers continue to pull back, the inventory stockpiled in the third quarter could result in lower demand in the fourth quarter as inventories are worked off.  Businesses are also reluctant to put capital to work given the uncertainty of what might happen at the end of the year.

Again, blame the Fiscal Cliff.  The decrease in corporate investment can be seen in manufacturing, which declined in November for the first time in four months.

MMC-2012-11-Inside GDP


First, the good news.  The U.S. created nearly 150,000 new jobs in November, despite Hurricane Sandy, which hit on October 29th.  It was feared Sandy could knock up to 150,000 jobs off the November tally so anything over 100,000 was a pleasant surprise.

Going forward, Sandy could help add jobs as the East Coast rebuilds.  The market was also pleased with the unemployment rate, which went down to 7.7%, its lowest level since December 2008.

The bad news?  October and September’s job increases were revised a combined 49,000 jobs lower, not the trend you want to see.  Also, the decline in the unemployment rate was mainly due to 369,000 workers claiming they were unavailable to work, about 300,000 more than normal and probably due to Sandy.

MMC-2012-11-November's numbers

Overall, we are still positive on the prospects for the job market going forward, as a slowly recovering economy and resurgent housing sector should help put Americans back to work.

Again, however, the Fiscal Cliff is the wild card.  Of the nearly 5 million Americans who receive unemployment benefits, 40% are scheduled to lose their benefits at the end of the year if the U.S. is allowed to fall off the Fiscal Cliff.   If this happens, all bets are off for the employment market.


 Nothing much new to report on the inflation front.  Core inflation is still a bit on the high side, but we think the Federal Reserve is more than comfortable with these levels.

MMC-2012-11-Consumer confidence-Table-US

The University of Michigan consumer sentiment index plunged over eight points in November as consumers finally started to discount the possibility of the U.S. falling off the Fiscal Cliff.   Alternatively, the Conference Board reading hit a four-year high, so who are you going to believe?

Up to this point, it was generally believed most consumers were focusing on the improvement in the job market and the housing sector; the Fiscal Cliff didn’t appear to be on main street America’s radar screen.

Now it seems you can’t turn on the T.V. without getting an update of the current drama unfolding in Washington.  This can’t help but hurt consumer confidence.

MMC-2012-11-The consumer-Table-US

It’s too early to tell if the rapid deterioration in consumer confidence will impact retail spending, especially during the all-important holiday season. 

Hurricane Sandy took a bite out of October retail sales and November same store sales, as much of the East Coast was in lockdown mode at the end of October and early November.

MMC-2012-11-Storm Tossed

So far, however, the Christmas spending season has gotten off to a decent start with the National Retail Federation estimating Thanksgiving weekend spending was up 13% over last year at just over $59 billion.

This is lower than last year’s 16% increase, but still pretty good.  Many stores pulled out all the stops in order to lure consumers through their doors, with many big chains opening as early as 8:00pm Thanksgiving evening.

Consumers seemed to like the opportunity to work off their turkey dinners shopping, but it doesn’t look to have driven total sales higher as activity subsequently declined 7% on Black Friday itself.  Consumers are also buying more online, with more than 50% of holiday shoppers indicating they bought goods on the internet over the weekend.

Monday is the big day for online shopping.  Dubbed Cyber Monday because it is considered one of the busiest internet shopping days of the year, IBM’s Smarter Commerce arm estimates Cyber Monday sales increased 30% over last year as consumers opted to shop from the comfort of home versus joining the mad rush of shoppers looking for Thanksgiving weekend deals.

MMC-2012-11-we're still eating

A solid Thanksgiving weekend means merchants are off to a good start this holiday season, but it doesn’t necessarily mean the rest of the season will be strong. 

Consumers have been conditioned to shop early in order to take advantage of the Black Friday sales, then wait until just before Christmas when panicky retailers slash prices even further.  Remember, retailers have been stocking up given stronger demand earlier in the year so they have a lot of goods to sell.

So far, so good, but we probably won’t know until early January if the Fiscal Cliff kept consumers on the sidelines.


We continue to be very encouraged by the strength of the housing market.  Existing home sales remain strong and prices were up year over year for the eighth month in a row, the longest streak since early 2006.

Strong sales are making it harder for buyers to find homes to buy, with the inventory of unsold homes now well below normal levels.  In fact, of the homes sold in October, one third had been on the market for less than a month.  It’s rapidly becoming a seller’s market.

MMC-2012-11-Gaining ground

While new home sales were down marginally on a month to month basis, we don’t expect this situation to last.  More new homes will need to be built and this will drive economic growth higher.

Of the 1.4% increase in fourth quarter GDP that Macroeconomic Advisers is estimating, 0.4% is attributed to new home construction.

MMC-2012-11-Building optimism


The trade deficit narrowed to its lowest level in nearly two years due to a smaller petroleum deficit in September.  Strong commercial aircraft, heavy machinery and farm goods helped drive exports to record levels.  Overall, a positive month for trade and one of the reasons third quarter GDP was revised higher.

The Fiscal Cliff is the key.  If a deal can be reached before year-end, some pent up demand will probably be released in the first quarter.  The fourth quarter might still be weak, however, as consumers and businesses have taken cautious stance.  If the U.S. falls off the cliff and no deals are made in early January, a recession could be soon to follow.

The Canadian Economy

MMC-2012-11-Economic Growth-Table-CAD

In the U.S., all the talk is about the battle between the Republicans and the Democrats and the threat of the U.S. falling off the Fiscal Cliff.

In Canada, all eyes are focused on the NHL lock-out.  In a country where some still lobby for a new national holiday celebrating the sport, hockey is part of the Canadian fabric and plays a not-insignificant role in the economy.

The Bank of Montreal’s Doug Porter estimates a cancelled season could trim 0.1% off Canadian GDP, while brewer Molson Coors recently blamed the lack of action for a 5% drop in the Canadian unit’s profits. Add in more trivial factors like a declining housing sector and an overleveraged consumer, and the prospects for Canadian growth looks subdued at best.

MMC-2012-11-whoo hoo Gary Bettman

It’s been a long time since we have said this but, Fiscal Cliff aside, we are becoming more disposed to the prospects for U.S. economy and less so for the short-term prospects of the Canadian economy.

It seems Canadian Finance Minister Jim Flaherty agrees, recently trimming growth estimated for 2013 to 2% from 2.4% and postponing by a year plans to balance the Canadian budget.  Flaherty now expects Canada to balance its books in 2016-17, which is still better than most developed nations.

Don’t get us wrong, Canada is still in better shape than most countries and is seen as a model of financial stability around the world.  Heck, the Brits even poached the head of our central bank to run the Bank of England – the first non-Briton to become Governor in its 318 year history.

Of course England tried this with their national football team, bringing in a Swede and then an Italian, with less than satisfactory results.

Canada has some headwinds on the horizon and now ex-Bank of Canada Governor Mark Carney may be timing his exit well.  Not sure about the timing of his new job, however.  Perhaps he should have talked with ex-England managers Sven-Goran Eriksson or Fabio Capello.

MMC-2012-11-Cloudy horizon


While there may be some concerns about economic growth in Canada, so far the job market is not showing it. 

Canada created nearly 60,000 new jobs in November, nearly all of them full time and from the private sector.  Wage growth declined, however, indicating that perhaps they were also lower paying jobs.

Canada, like most developed nations, is experiencing a shortage of skilled labour.  CIBC recently indicated 30% of Canadian businesses are having trouble filling certain skilled positions and vacancies for these positions have increased 16% over the past year.


Inflation remains a non- issue in Canada.

MMC-2012-11-Consumer confidence-Table-CAD

MMC-2012-11-The consumer-Table-CAD

Canadian consumer confidence continues to strengthen, but retail spending in September was virtually unchanged from last year in real terms and basically unchanged from the previous month.

Canadians are becoming more cautious and might be finally taking the Bank of Canada’s advice and reducing their household debt.  This is a good thing, though it will provide a headwind for economic growth going forward.


Because the housing sector was 16.5% of Canadian GDP in 2010 and 4.7% in 2011, any decline in activity is likely to be a headwind for the Canadian economy.


Sales have started to move lower and many expect prices to follow soon.  The question is, how much.

The two biggest factors impacting house prices are interest rates and unemployment rates, and so far both are helping prices stay firm.  Interest rates are low and not likely to move higher anytime soon while the job market, as highlighted above, continues to surprise to the upside.

Also, the economic prospects for Canada’s main trading partner (70% of Canadian exports head to the U.S.) looks to be brightening (Fiscal Cliff aside).

Yes, prices in Vancouver have started to fall, with Greater Vancouver prices off 5.5% since the peak last year and the West Side off 8.4%, but if you take Vancouver and Toronto out of the equation, prices in Canada were up 2.5% year over year in October.

Housing might not be a big positive driver for economic growth over the next few years, but we don’t see a U.S.-style collapse either.


The trade deficit declined in September as transportation, farm and fishing, and intermediate goods exports increased.  Energy and mineral exports also rebounded.

The Canadian economy faces some headwinds next year as consumer spending pulls back and the housing sector consolidates.  As long as the Fiscal Cliff doesn’t drive the U.S. into recession, however, the Canadian economy should be just fine, even without Mr. Carney.