Highlights This Month
- Like stocks, yields didn’t just move in one direction last month
- Over $17 Trillion of the World’s debt market traded at yields below zero
- Policy uncertainty makes it hard for companies to make capital spending decisions
- Argentina’s stock market, bond market and currency plummeted
- The impact the 2020 US election could have on the markets
Nicola Wealth Portfolio
Returns for the Nicola Core Portfolio Fund were 0.0% in the month of August and is +6.5% year-to-date. 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 0.2% in August, and is +4.7% year-to-date. Overall general bond market returns were driven by duration exposure as Government of Canada bond yields moved lower. If one matched market duration for the month, duration alone would have led to returns of 2.4%. Our Nicola Bond Fund maintains a low duration and focuses on steady returns and thus did not benefit significantly from government yields moving lower. August felt like a typical summer month being relatively calm until tensions between China and the United States escalated again due to the trade war. Credit spreads were volatile but did not move significantly. Low issuance for the month continues to provide support as there is limited supply.
The Nicola High Yield Bond Fund returned 0.9% in August, and is +4.7% year-to-date. Currency contributed approximately 0.5% from returns as approximately half the fund has USD exposure. The high yield market see-sawed through the month as a risk-off environment weighed on markets before rebounding to end the month on a positive note. The disparity between high quality and low quality issues continues to widen, marking multi-year highs, as high quality high yield names continue to outperform. The Nicola High Yield Bond Fund is overweight cross-over credit (a bond that is borderline between investment grade and high yield) and has benefited from the rally of quality names.
The Nicola Global Bond Fund was down -2.1% for the month. The Nicola Bond Fund returns were driven lower by the Templeton Global Bond fund which was down approximately -3.9%. Weakness was broad based in emerging markets with Mexico, Brazil, and Argentina suffering losses. Broad market losses were caused by the on-going trade war and global central banks signaling concerns on slowing global growth.
Weakness in emerging country currencies followed as emerging market ETF’s saw significant outflows. The Templeton Global Bond fund’s largest detractor for the month was Argentinian bonds. Although a small position for the fund and sized according to a risk-adjusted return perspective, Argentina had been on a path to be fiscally prudent through austerity, but a surprise presidential primary saw opposition candidate, Alberto Fernandez as the new favorite to take office. The market reacted violently with concerns that Fernandez would roll back policies and the Peso lost a quarter of its value in three days.
The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.3% and +0.4% 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 5.6% for the Nicola Balanced Mortgage Fund. The Nicola Primary Mortgage Fund had 25.4% cash at month end, while the Nicola Balanced Mortgage Fund had 14.3%.
The Nicola Preferred Share Fund returned -5.3% for the month while the BMO Laddered Preferred Share Index ETF returned -5.4%. Five year Government of Canada bond yields moved significantly lower ending the month at 1.19%. The month also saw large outflows in preferred share ETF’s and a pick-up in shorting of preferred ETF’s causing continued pressure on the market. The sell-off for the month brought valuations close to the lows last seen in 2016 and after adjusting for beneficial tax treatment of dividends, preferred shares are currently yielding approximately 1.2% more than high yield.
The S&P/TSX was up +0.4% while the Nicola Canadian Equity Income Fund was -1.3%. Materials (more specifically Gold) and Information Technology were the largest positive contributors to the Index. Financials was the largest headwind. The underperformance of the Nicola Canadian Equity Income Fund was mainly due to the underweight in Gold, underweight in Information Technology (where we have no weighting) and also Industrials. On an individual stock basis, the top positive contributors to the performance of the fund were Spin Master, Cargojet and Wheaton Precious Metals. Largest detractors to performance were Ag Growth, Methanex, and ATS Automation. We added to our Gold exposure in August by adding Franco Nevada to the portfolio.
The Nicola Canadian Tactical High Income Fund returned -0.5% vs the S&P/TSX’s +0.4%. The relative under-performance was mainly driven by the Nicola Canadian Tactical High Income Fund’s positioning within the materials sector (overweight West Fraser Timber, Methanex and underweight gold stocks) and zero exposure to utilities, real estate and information technology (Shopify alone contributed 41bps to the S&P/TSX’s total return which partially offset the Canadian Banks’ underperformance).
The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 64.5% (64% prior) and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market.
During August, the Nicola U.S. Equity Income Fund returned +0.6%, while the S&P500 returned -1.6%.
Relative performance was driven by quality growth names including Costco, Estee Lauder, Medtronic; defensive names including utility company Nextera Energy and telecommunications company Crown Castle; as well as a rebound in Newell Brands. These more than offset drags from energy names EOG Resources and Valero Energy. In terms of notable trades, we bought Pepsi, adding to our defensive positions; and trimmed Apple after recent strong performance.
The Nicola U.S. Tactical High Income Fund returned -5.3% vs -1.6% for S&P 500. The Nicola U.S. Tactical High Income Fund’s relative underperformance was due to being underweight defensive sectors (Utilities 0%, Real Estate 0% and Consumer Staples 4.4% vs 7.6% benchmark) and security selection within the Consumer Discretionary sector; 4 stocks within this sector dragged performance down close to 3.2%. While the returns have been disappointing in the month of August due to some of our discretionary names underperformance, our investment style/strategy has been consistently providing strong risk-adjusted returns and a tight monthly & 12-month rolling return distribution since the Nicola U.S. Tactical High Income Fund’s inception.
The Nicola U.S. Tactical High Income Fund has been very selective in deploying capital. We were still able to generate double-digit annualized premiums with double-digit break-evens. The Nicola U.S. Tactical High Income Fund’s delta-adjusted equity decreased from 46.9% to 51.9%. Two new names added to the portfolio were Hormel Foods (Consumer Staple with products like SPAM, Skippy peanut butter, Jennie-O and other value-added refrigerated foods) & Tapestry (Consumer Discretionary with names such as Coach, Kate Spade & Stuart Weitzman). 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 -1.2% vs -1.2% for the MSCI ACWI (all in CDN$). Country allocation contributed to performance with the Nicola Global Equity Fund underweight the U.S. and overweight Japan. Sector contribution was mixed as the Nicola Global Equity Fund benefited from being overweight consumer staples while being slightly underweight Healthcare and Utilities. Performance of our managers in descending order was Pier 21 Global Value +1.7%, Pier 21 C Worldwide +0.3%, Nicola EAFE Quant -1.6%, Lazard -2%, Edgepoint Global -2.7%, and BMO Asian Growth & Income -3.1%.
The Nicola Global Real Estate Fund was +1.6% in August vs. the iShares (XRE) +4.1%. Publicly traded REITs exhibited strong performance in August against the backdrop of declining (and in many cases negative) long-term yields. The vast majority of government bonds are trading at or near 12-month lows. The dearth of sufficiently yielding investment products has seen many investors stretch for yield and real estate has been a beneficiary. As it pertains to the Canadian REIT complex, the interest rate environment has become increasingly supportive. We have tilted the portfolio towards reasonably valued REITs with superior per-unit growth profiles. One third of the portfolio is invested in US securities which benefited from a rise in the USD/CAD exchange rate. Overall we think that conditions are good for real estate.
We report our internal hard asset real estate Limited Partnerships in this report with a one month lag. As of August 30th, July 31st performance for the Nicola Canadian Real Estate Limited Partnership was -+0.4%, Nicola U.S. Real Estate Limited Partnership +0.7%, and Nicola Value Add Limited Partnership +1.1%.
The Nicola Alternative Strategies Fund returned +1.2% in August (these are estimates and can’t be confirmed until later in the month). Currency contributed +0.6% to returns as the Canadian dollar weakened through the month. In local currency terms, Winton returned 4.8%, Millennium 1.2%, Bridgewater Pure Alpha Major Markets -6.7%, Verition International Multi-Strategy Fund Ltd 0.6%, Renaissance Institutional Diversified Global Equities Fund 3.3%, RPIA Debt Opportunities -0.7%, and Polar Multi-Strategy Fund -0.3% for the month. Overall, a strong month in terms of performance with Winton and Renaissance offsetting weakness in Bridgewater. Bridgewater manages a diversified portfolio across many asset classes; unfortunately the diversification was not able to offset pain felt in markets with long equity market exposure and long emerging market currencies leading to negative returns for the month.
The Nicola Precious Metals Fund returned +11.9% for the month while underlying gold stocks in the S&P/TSX Composite index returned 16.8% and gold bullion was higher 8.5% in Canadian dollar terms. Although a very robust month for the precious metals fund overall, our equity exposure in gold stocks through the RBC Global Precious Metals Fund underperformed due to exposure in select junior and mid-sized mining companies. The flow of funds into gold help drive returns materially higher with large cap names such as Barrick Gold, Agnico Eagle, and Kinross Gold all up over 20% for the month. Our fund has a bias towards mid-cap names and select exposure in K92 Mining, Northern Star Resources, and Oceanagold were each down around 10% due to name specific issues and thus created a drag on returns.
We previously discussed some longer term challenges facing markets and the global economy, including issues to be aware of and taken into consideration when creating financial plans and structuring longer term investment portfolios, but not something of immediate concern.
Last month markets appeared to leap forward and start discounting some of these challenges today, or at the very least give us a preview of what might transpire if some of the more negative scenarios start to play out. A shift towards defensive assets was clearly evident with gold and the Japanese Yen rallying, but it was the continued collapse in bond yields and inversion of the two year versus ten year US yield curve (two year yields trading higher than 10 year yields) that captured most of the headlines.
An inverted yield has historically been a near perfect predictor of recession, and while the three month versus 10 year yield curve turned negative for the first time earlier in the year, the more commonly scrutinized two year versus 10 year curve remained positive, until last month.
Not ready to give into the bears just yet
The continued trade war between the US and China is cited as the main culprit behind the market jitters, though there are plenty of additional geopolitical events vying for investor attention. Is the defensive market action seen last month justified? Are we headed for a recession, and perhaps more importantly for investors, does the bull market see a bear market staring back at it? While we agree investors need to be cautious in the current environment, we are not ready to give into the bears quite yet and will spend the rest of this commentary detailing why.
The defensive move in risk assets last month was in full display with stocks, as the S&P 500 fell 1.6% (US dollar terms). Most sectors suffered steeper declines, however, and the index would have been inflicted a worst drubbing if not for gains in traditionally defensive sectors real estate, utilities, and consumer staples. Along with low beta stocks, defensive sectors and companies are driving the market higher and now dominate the portfolio of momentum investors. Volatility was also evident, with the S&P 500 posting a daily move of over 1% twelve times and an average daily move of 1.1%. Canadian stocks ended the month in the black, with the S&P/TSX gaining 0.4%, but only due to big moves in gold (gold sector gained nearly 17% in August) and technology standout Shopify (+22.3% last month!).
Like stocks, yields didn’t just moved in one direction last month.
One of the reasons defensive stocks were in demand last month was because many can also be characterized as bond proxies given they pay healthy and stable dividends. As evidenced by falling yields, bonds of all types were in near frantic demand in August. Last month we wrote about the potential Japanification of global bond markets, with yields continuing to converge to the low levels experienced in Japan over the past couple of decades. This trend appeared to go into overdrive in August, especially in Europe, with German 10 year Bunds trading as low as -0.7%. Like stocks, yields didn’t move in just one direction, however, volatility was actually quite high, but overall, the cumulative flows into bond funds this year shows bonds are in demand.
Makes sense. If you are worried about the economy and want to become more defensive, owning bonds would be a normal and rational move by investors. How much you are willing to pay is of course the key variable one faces with the purchase of any investment asset, but the strategy of buying bonds in anticipation of a recession would appear pretty sound.
Over $17 trillion of the world’s debt market traded at yields below zero last month.
What doesn’t make any sense is buying bonds paying a negative yield. We get the fact assets can become very expensive in certain circumstances, but why would any investor buy bonds paying a negative yield. It defies logic let alone any economic theory we’ve ever been exposed to. And yet over $17 Trillion of the World’s debt market traded at yields below zero last month. Granted, a large chunk of these were in Japan (nearly half), but the entire German yield curve went negative last month, as did that of Switzerland and Holland. Sovereign debt yielding over 5% has become a rare commodity as have lower risk options paying positive yields. According to Bank of America, 95% of the world’s available investment grade yield is confined to the good old US of A, for now. We are over simplifying the situation in the bond market to some degree. In a global marketplace where there is a shortage of US dollars, there are legitimate reasons why an entity might purchase a negatively yielding asset, but we are not one of them.
Central Banks are behind the move to negative yields as overnight rate continue to move lower.
India and New Zealand started lowering rates earlier in the year with Thailand and The Philippines following suit in August. Malaysia, Indonesia, South Korea, and South Africa have also lowered rates recently. The ECB’s deposit rate is already minus 0.4%, but many expect it to go even lower when the ECB next meets on September 12th. Given how much central banks have historically lowered rates during a recession, overnight rates could fall even deeper into negative territory during the next economic downturn. All this is putting a lot of pressure on the US Federal Reserve and its Chairman Jerome Powell. The Fed lowered rates 25 basis points at the end of July, but many were expecting more, especially President Trump. Given where three month bills are trading, the market believes at least another 50 basis points are in order.
The market’s belief that the Fed was falling behind was enforced last month by shape of the US Government yield curve, namely two year yields falling below 10 year yields for the first time since June 2006. As mentioned above, an inversion has preceded every post World War II recession so investors tend to take these things fairly seriously.
Some caveats are required before throwing in the towel on the current expansion, however. While it may be true an inversion has proceeded every recession, it’s not true that every inversion has been followed by a recession. The yield curve was flat for most of the 1990’s and inverted briefly in 1998 without being followed by a recession. In a recent Barron’s article, ARK Investment Management’s Catherine Wood scrutinized historical data to find the yield curve was inverted more than 50% of the time during a 50 year stretch starting in the 1860’s. She explained the inversion was due to technologically enabled innovation causing “good” deflation, an environment she believes is also behind today’s inversion. Low inflation is certainly a factor many use to down play the current negative inversion signal, as are low and even negative bond yields globally. The theory behind why the inverted bond yield has been such a good recession indicator in the past is because it is usually caused by tightening central bank causing interest rates to move higher. That’s not happening today, rates are moving lower. Much lower in fact.
“This time it’s different”.
We don’t want to ignore the negative implications of the yield curve inversion last month. To quote Sir John Templeton “This time it’s different” are the four most dangerous words in investing”. The decline in yields last month and resulting inversion are clear signals investors are worried, and the trade war between the US and China likely tops their list. On August 1st, President Trump tweeted that an additional $300 billion in Chinese imports would be subject to 10% tariffs, which was countered by additional tariffs on US export by China. China also allowed it’s currency to weaken and was subsequently labeled a currency manipulator by the US. Trump has also ordered American companies to immediately start looking for an alternative to China, while at the same time claiming China wants to make a deal “very badly” and has asked the US to “get back to the table”, a claim Chinese officials deny. Regardless, the two sides have agreed to talks again in September, news of which caused markets to move higher. Apart from the direct negative impact of the tariffs, the uncertainty around what may or may not happen has led to a spike in US economic uncertainty.
Policy uncertainty makes it hard for companies to make capital spending decisions.
The fallout for global growth so far has centered on the manufacturing sector, with Germany being exposed as particularly vulnerable. The service sector, on the other hand, has remained strong, likely due to its reliance on the US consumer, which makes up 17% of the world’s GDP.
The global economy also relies on China, and fortunately China has some options available to it in order to counter a slowing economy. Chinese policy makers, in fact, have plenty of room to continue cranking up more stimulus as needed. The impact of the higher tariffs, for example, can be blunted by letting the Chinese yuan weaken, which as mentioned above, China looks to be doing already. Also, in early September China lowered bank reserve ratios by 25 basis points to their lowest level since the financial crisis, freeing up an estimated $126 billion in lending capacity. The ability for China to stimulate growth to hit their targets is one of the reasons it’s too early to call a recession just yet.
The trade war could cut US economic growth by 1% through 2020.
As for the US, markets were shaken in early September with news purchasing manager indexes had fallen into contraction territory for the first time in three years, mirroring global trends. The Federal Reserve economists believe the trade war could cut US economic growth by 1% through 2020, citing uncertainty as evidenced by the increase in newspaper articles talking about slowing growth and negative comments on corporate earnings conference calls. In conjunction with falling bond yields and an inverted yield curve, investors could be forgiven for conceding that a recession is inevitable. The consumer remains strong, however, with unemployment remaining near 30 year lows and wage growth firming. Concerns of lower capital spending due to economic and policy uncertainty are valid, but a strong US consumer is tough to bet against.
Argentina’s stock market, bond market and currency plummeted.
As for other geopolitical risks hitting the headlines last month, the list was long. Poor election results in an Argentinian election primary put the future of the present government and their economic reforms in doubt. As a consequence, Argentina’s stock market, bond market and currency plummeted. Same old same old for Argentina unfortunately.
Governments globally are becoming more nationalistic.
India revoked Kashmir’s special status last month, sparking concerns a future skirmish with Pakistan might unfold. The threat of a military conflict between the US and Iran continued to unfold as economic sanctions continue to cripple the Iranian economy. Japan and South Korea ended their intelligence sharing arrangement as the two countries bicker over trade issues. In Brazil, fires threaten the Amazon ecosphere which, according to French President Emmanuel Macron is responsible for 20% of the world’s oxygen. Brexit remains as uncertain as ever, with the October 31 deadline fast approaching and no resolution in sight. And finally, protests in Hong Kong threaten the future of the Asian financial hub.
Most of these events are noise, not because their threats aren’t real, but because the ability for the market to discount their implications is very low, so they are largely ignored. There is a common thread running through all of them, namely governments globally are becoming more nationalistic. Even the fires in the Amazon could be characterized as a nationalistic Brazilian government looking after its own interests to the detriment of the environment and global warming. Does this worry us? You bet it does! But what does this mean for investment assets (we actually have some ideas on this we will be discussing next month, but we digress). The world has become a very dangerous place and the margin of safety for the global economy is lower as a result. But until we see it in the numbers, the market will generally look the other way.
2020 US election impact on the markets.
If it’s hard to ignore the environment or any of the actual shooting wars threatening to break out around the world, ignoring Donald Trump is even harder. The Donald knows how to command an audience and when he speaks or tweets about tariffs and China, he can move the market. Most of the time, however, he talks out of both sides of his mouth and is hard to take seriously.
He claims China is paying for the tariffs, but then delays some tariffs until after the Christmas shopping season in case it impacts American consumers. He berates the Federal Reserve for not cutting interest rates, and yet brags how strong the US economy is. According to The Washington Post, after 928 days in office (up to August 5th) Trump had made 12,019 false or misleading claims. His behavior is un-Presidential at best. Last month he brought up the idea of the US buying Greenland, an autonomous Danish territory. When the Danish Prime Minister called the idea “absurd”, Trump accused her of being “nasty” and canceled an upcoming state visit to Denmark, leaving citizens of Denmark baffled. Did the leader of the most powerful country in the free world just cancel a meeting because his feelings were hurt?
Despite being disturbingly erratic, Trump’s support remains steady, and there is a very real chance he could be re-elected next year. Joe Biden is the current favorite to win the Democratic nomination and run against Trump. He’s old and not very exciting, but markets would probably be fine with “Sleepy Joe”. With all his faults, markets would also be fine with another four years of the Donald. Again, the market has a hard time discounting events it can’t predict or determine the adverse implications of, for which there are too many to list with Trump. If Joe Biden isn’t the Democratic nominee, however, and a more progressive leader like Bernie Sanders or Elizabeth Warren runs against Trump, and wins, well that’s a whole different issue for the market. Ultra-wealthy voters are going to love Warren’s plans for a wealth tax and she’s considered mainstream compared to Sanders. It’s still too early to get into a lot of details on the 2020 Presidential election, and we’ll have plenty of time over the coming months to analyze the trends, but it is a potentially moving event that investors will need to keep an eye on.
A brief guide to the end of the world.
It can be easy these days to get caught up in the headlines. Low interest rates, inverted yield curve, trade wars, along with all the geopolitical risks facing the world paint a pretty gloomy picture. A recent book by Bryan Walsh called “End Times: A Brief Guide to the End of the World” takes the debate one step further by chronicling a range of threats that could doom us all, and not just our investment portfolios. Mr. Walsh highlights super volcanoes, asteroids, and killer robots as dangers to the planet, with weaponized bioengineered super viruses being perhaps at the top of the list.
A more quantitative theory based on Bayes’ Theorem was detailed in a June 27th WSJ article by William Poundstone and concludes there is a 50% chance life on earth will come to an end, in 760 years. We are not sure how, or when, the market will start discounting this potential event. While we are wary of what will happen in the next recession, we also believe investors have to guard against becoming too bearish. Market action last month gave some hints as to what might happen, namely interest rates will sink to very low levels, but we are not there yet. The defensive trade is likely overdone and some retracement is likely. And even when the next recession does come, it won’t be the end of the world, at least not for another 700 years or so.
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.