By Rob Edel, CFA
HIGHLIGHTS THIS MONTH
- U.S. indices hit a historic triple top & the consumer-discretionary sector ruled.
- The New Normal Bubble: investors influence the bond market.
- Investors are willing to pay more for stocks with low volatility but slow growth.
- Paralelled stock and bond prices are sending a red flag.
- Shocking the market: will there be a rate increase in 2016?
- Americans are losing confidence in Yellen after prolonged uncertainty.
- Who controls whom? U.S. elections vs. U.S. economy.
- We predict more caution from the Fed, for now.
The NWM Portfolio
Returns for NWM Core Portfolio increased a strong 1.2% for the month of August. 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 backed up in August, causing the yield curve to flatten in Canada. In the U.S., both short term and long term interest rates moved higher. NWM Bond was up 0.6% as our two alternative managers benefited from a favourable move in credit spreads.
NWM High Yield Bond had another strong month in August, continuing six consecutive months of positive returns. It returned 2.0% in August, following a 3.0% return in July. With limited new issuance supply during the quiet summer months, the high yield bond market continued to be pushed higher. Despite weak corporate fundamentals—declining revenues, rising leverage—U.S. high yield bonds continue to be technically supported by the global chase for yield. Also benefiting from a global search for yield were global bonds, with NWM Global Bond up 0.7%.
The mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning +0.3 and +0.5% respectively in August. 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 4.3% for NWM Primary and 5.6% for NWM Balanced. NWM Primary ended the month with cash of $15.3 million, or 9.5%. NWM Balanced ended the month with $36.6 million in cash, or 8.5%.
NWM Preferred Share had another strong month for August returning 1.9% while the BMO Laddered Preferred Share Index ETF was up 1.2%. Positive August returns pushed year to date performance into positive territory with the NWM fund up 1.7% versus -1.5% for the market.
The month started off with a bang before whimpering for the last few weeks as anticipation for new issuance from banks caused investors to start selling product to raise cash for the impending supply coming to market. And it came with a vengeance. TD came to market with a $300 million dollar deal that was upsized to $1 billion dollars, the largest deal ever. With 64 institutional buyers, the deal was well received from traditional fixed income investors and felt more bond-like than preferred share-like in terms of its audience. Although additional supply coming to market is never a good thing, the appetite from non-traditional preferred share investors bodes well for more stability in the marketplace going forward as the investor base broadens.
Canadian equities were mainly unchanged in August, with the S&P/TSX +0.3% (total return, including dividends), while NWM Canadian Equity Income and NWM Canadian Tactical High Income were up 2.1% and 2.4% respectively. Both funds benefited from having no exposure to the gold sector, which was down 16% for the month.
In NWM Canadian Equity Income, we trimmed our positions in Guardian Capital and ATS Automation and established a new position in Onex. We also sold our holding in CGI and bought Constellation Software. In NWM Canadian Tactical High Income, we also trimmed Guardian Capital, and added to our existing position in Morneau Shepell.
Foreign equities were moderately stronger in August with NWM Global Equity up 0.6% compared to a 0.4% increase in the MSCI All World Index and a 0.6% rise in the S&P 500 (all in Canadian dollar terms). Of our external managers, all produced positive returns, with the exception of BMO Asia Growth & Income, which was down 0.2%. Edgepoint led the way +1.7%, followed by Lazard Global +0.7%, Pier 21 Value Invest +0.4%, and Pier 21 Carnegie +0.1%.
NWM U.S. Equity Income increased 0.9% in U.S. dollar terms and NWM U.S. Tactical High Income rose 2.1% versus a 0.1% increase in the S&P 500 (all in U.S. dollar terms). In NWM U.S. Equity Income, a sector overweight in financials and an underweight in utilities helped returns. There were no new additions to the fund, but we did trim our position in AIG.
As for the NWM U.S. Tactical High Income, we benefited from not owning any telecom or utilities, as interest rate sensitive stocks sold off during the month. We added a new short put position in American Express.
Real estate was down slightly in August with NWM Real Estate -0.7%, an undestandable result given interest rate sensitive securities were under pressure and the iShare REIT Index was down 5%.
NWM Alternative Strategies was up 1.8% in August (these are estimates and can’t be confirmed until later in the month). All our managers ended the month in positive territory, with the exception of trend follower Winton, which declined 1.4%. Of the other Altegris feeder funds, Brevan Howard was +0.4%, Millenium +1.6%, and Citadel +3.0%. MAM Global Absolute Return Private Pool was +1.1%, RP Debt Opportunities +1.5%, Polar North Pole Multi Strategy +1.1%, and RBC Multi-Strategy Trust was flat.
Precious metals gave back some of their strong recent returns, with NWM Precious Metals -7.9% and gold bullion down 2.5% in Canadian dollar terms.
August In Review
The Hamptons (a popular vacation spot for well healed Wall Street bankers) effect was in full force in August, with trading volume down and market volatility subdued. The S&P 500 increased 0.6%, marginally bettering the S&P/TSX’s 0.3% gain.
Even with this lack of excitement, U.S. indices managed to hit a historic triple top in mid-August, with the Dow, S&P 500 and Nasdaq Composite simultaneously making all-time highs for the first time since the tech bubble of the late 1990’s. Despite this trifecta of good news, the only sector to reach new highs during the month was the consumer-discretionary sector, comprised of such well-known companies as McDonalds, Amazon, and Starbucks.
Historically, a lack of breadth in a bull market has been a bit of a red flag. Case in point, when the tech boom ended in March 2000, only two sectors, technology and industrials, were making new highs. So does this mean the market could be topping out? It’s possible, but not because the market looks like it did in 1999, because it doesn’t.
In 1999, the Nasdaq was up a scorching 86% for the year and had notched an annualized 18% over the previous decade. So far this year, the Nasdaq is up just over 5% and has annualized under 10% over the past ten years. According to the American Association of Individual Investors, only 31% of investors are presently bullish on the market as opposed to 60% on December 30, 1999. Even more significant, stock valuations are lower now than in 1999, with the S&P 500’s forward P/E multiple at 17 times versus 24 times in late 1999, and the Nasdaq’s forward P/E multiple is half of what it was in 1999. In retrospect, there were clear signs the market was in a bubble at the end of the 20th century. Should we be concerned about today’s market? Yes and no. The current stock market is much more complicated.
The bond market is pretty straight forward. It has bubble written all over it, and its inflated valuation is beginning to impact the stock market. Because interest rates are so low, bond investors in search of a decent yield are bidding up the price of dividend-paying stocks. Investors are paying for dividend yield and not earnings growth, and it’s changing the traditional valuation metrics for stocks. Yale professor Robert Shiller refers to this as the “new normal bubble”.
Historically, markets have been positively correlated to earnings growth, but negatively correlated to dividend yields, meaning dividend yields are moving higher when stock prices are going down. This makes sense because dividends tend to be less volatile than earnings. Earnings are cyclical and will fluctuate with the economy. Dividends tend to be more fixed, as companies try to avoid cutting or missing a dividend payment, even if their earnings fall. Because of this, when the price of a stock goes up, the dividend yield tends to move lower. Over the past five quarters, however, correlations between the market and dividend yields have spiked into positive territory, meaning companies have been increasing dividends such that their yield is increasing even as the share price has been going up.
Over the past year, in fact, S&P 500 companies have paid out a near record 38% of their net income in dividends. Add in share buy backs, and corporations have returned 112% of their earnings to shareholders in the first two quarters of this year. Because companies know investors are valuing dividends more than earnings, they are doing everything they can to boost their dividend rates even higher. Of course, paying out all your earnings to shareholders is not a sustainable long-term strategy.
As a result of the market’s appetite for yield, relative stock valuations are getting distorted as reliable dividend-paying companies are being bid up in price with investors crowding into boring slow-growth sectors like consumer staples and utilities. Typically, these stocks have less sensitivity to movements in the market, which in industry terminology means they have a low beta. Low beta means low volatility, but it also used to mean low valuation. Not so much lately, however, as investors are willing to pay more for these low beta stocks compared to companies with higher growth rates. It’s the opposite of what one would traditionally expect, and somewhat concerning.
In addition to the special attention being paid to dividend-paying stocks, what’s also concerning is the general complacency of investors in regards to market risk. Volatility, as measured by the VIX, has fallen to 20-year lows as S&P 500 stocks have traded in a very narrow range over the past couple of months. In addition, investors appear to be taking aggressive long futures positions on Dow and S&P 500 indices.
Obviously they aren’t worried about a lack of market breadth leading to a market correction. What they are betting on is the bull market broadens with more stocks and sectors participating in the rally. While the overall market didn’t move much last month, it did broaden, with smaller companies outperforming, and out of favour sectors, like financials, finally catching a bid.
Alternatively, utilities and consumer staples gave back some of their recent gains. If market leadership is able to successfully rotate into other sectors other than those dominated by defensive high dividend-yielding stocks, perhaps this rally can continue to move higher?
Maybe, but along with a broadening market rally, traders are also betting on interest rates staying low for the foreseeable future. The lack of strong economic growth, as we will discuss below, was disappointing last month. The future path of interest rates will have a large say on what happens to stocks, and asset returns in general.
Capital market valuations are justified by ultra-low interest rates, but there are some troubling signs the current environment could be changing. Typically, stocks and bond prices move in opposite directions. When stocks do well, bond prices go down (meaning bond yields go up). It’s the basis of modern portfolio theory. One holds a combination of stocks and bonds because when stocks are doing poorly, stronger bond returns should help offset some of the losses. Alternatively, when interest rates are going up, often due to a stronger economy, bond prices come under pressure but higher stock prices should more than make investors whole again.
Lately, however, stock and bond prices have been moving in the same direction, with stocks and bonds both going up (and bond yields down). This doesn’t make sense because interest rates should be going up if the economy is getting better, which is logically why stocks would be moving higher. Historically it has also been another red flag for the market.
In early September, stocks and bond yields moved in the same direction in 11 of the previous 30 trading days. Since the financial crisis, such a deviation in the normal bond/stock relationship has often coincided with a market shock. The likely cause of the current breakdown in the relationship is investor belief that the Federal Reserve will keep interest rates low, forever. Investors don’t care about the economy and are only focused on central bank monetary policy and the resulting low discount rate for stocks. As long as the central banks are filling the punch bowl, asset prices can continue to move higher. Where the shock could occur is if they are wrong and interest rates don’t stay low forever.
Low interest rates have been the norm since the great recession, and the yield curve has been flattening for the past two and a half years, which typically indicates the economy is slowing and longer term interest rates could move even lower in the future. Most strategists, in fact, don’t see 10-year bond yields rising much from current levels by the end of the year, which would leave 10-year rates about 1% less than they were forecasting at the beginning of the 2016. But what if the Federal Reserve starts increasing short rates? Would that be enough to shock the market?
Probably not, if they just raise rates just once. Fed fund futures are already pointing to a greater than ever chance the Fed will increase interest rates at least once before the end of the year, and 71% of the 62 economists recently surveyed by the Wall Street Journal agree.
If, however, the Fed throws the market a curve ball and raises rates in September and December, would investors start to change their view on lower interest rates forever? Could the Fed effectively call an end to the equity bull market by adopting a more hawkish monetary policy? It’s tough to call, because even the Fed doesn’t seem to have a good handle on where interest rates are going. Case in point, a chart presented recently by Fed Chairperson Janet Yellen indicated the Federal Reserve range for interest rates by the end of 2018 is anywhere from 0% to 4.5%.
Along with this apparent uncertainty, the Fed has consistently overestimated economic growth, and thus how fast they would be able to normalize interest rates. As a result, most Americans are losing faith in the central bank and its leader. A recent Gallup poll found Chairwoman Yellen’s confidence rating at a mere 38% compared to over 70% for Alan Greenspan.
This lack of confidence is a problem for the Fed, and is one of the reasons they would like to make good on their previous statements in regards to increasing interest rates. The Fed would also like to have the option of lowering interest rates again if the U.S. economy goes back into recession. We still believe, however, the Fed will continue be very slow and measured in their approach to raising rates.
There is a growing consensus at the Fed that the long-term real natural interest rate, which is the rate which would keep inflation steady if the economy were at full capacity, has fallen sharply over the past 25 years. If the real natural interest rate is actually only 1% (versus 3.5% historically) and inflation were to reach the Fed’s 2% target, nominal rates would top out at only 3%. Because the Fed has cut short-term interest rates by an average of more than 5% in past recessions, even a move in short-term interest rates to 3% from 0.5% currently wouldn’t give the Fed enough room to cut rates sufficiently, leaving only more quantitative easing or negative interest rates as possible policy options. As such, some Fed governors argue the inflation target should move higher, say 4%, and then nominal rates would top out at 5% and leave the Fed room to lower rates a more typical 500 basis points if the economy were to go into recession.
Conveniently, higher inflation would also help the U.S. economy deleverage. Of course, manufacturing inflation has proven to be harder than anticipated and increasing interest rates would only make it harder. For this reason, the Fed will likely over promise and under deliver when it comes to normalizing interest rates.
A couple of other reasons we will see only one rate hike this year, are the economy and the U.S. election. Most forecasters are predicting third quarter economic growth should rebound from the weak showing in the first half of the year. However, employment growth came in a little light in August and is likely to continue slowing as the economy nears full employment.
Also, manufacturing indices pointed towards slower growth in August, with the ISM Purchasing Managers Index in contraction territory (falling below 50) for the first time since November 2012. Even the ISM Non-Manufacturing Index was weak, still above the magic 50 level, but materially lower than July’s level. Only the housing market provided some upside surprises with strong July housing starts and new home sales.
As for the election, it is typical for the Federal Reserve to keep a low profile during an election campaign so as to not appear favouring one party over another. Strong markets and a strong economy have historically been good for the incumbent party.
If the Fed raises rates, it could jolt the market, and might even cause the economy to slow. This would be bad for Hilary and the Democrats. More importantly, however, there are signs the uncertainty surrounding the U.S. presidential election is having a negative impact on the economy with businesses holding off on investment decisions.
Overall, we still believe the perceived risk of the upcoming U.S. election is greater than reality. Historically, the election result most favourable for markets has been a change of leadership, with the new president coming from the same party as the incumbent. Markets have also favoured a combination of a democratic president with a republican congress.
While polls are volatile, in fact much more volatile than the markets have been, so far they are pointing towards Hilary winning, which would mean a leadership change, but the same incumbent party (Clinton and Obama are both Democrats). The Republicans are also favoured to maintain control of the House of Representatives, and possibly even the Senate, also the most favoured combination historically.
So there are lots of reasons for the Fed to hold off increasing rates, and yet they keep telling us how much they want to start normalizing interest rates higher. They never intended to keep rates at such low levels for as long as they have, and they know a recession will leave them with very few options.
As mentioned last month, there appears to be a growing consensus amongst the developed world’s central banks that monetary policy isn’t doing the job, and may actually be holding the global economy back. The Federal Reserve is worried their credibility is at risk, and may feel they need to raise rates, even if the markets aren’t ready for it. They are in a tough spot, and appear to be alternating between hawkish and dovish statements. Certainly any strength in the U.S. economy would make the decision easier, and is why Chairwoman Yellen stresses the Fed is data dependent. We suspect the Fed will look for the opportunity to rise once in 2016, with an outside chance of increasing twice. The markets might correct in the short term, but any additional moves by the Fed will be very slow and measured. We don’t see rates moving up materially in the short end or long end of the yield curve. Not yet, at least.
What did you think of August’s economic activity? Let us know in the comments below!
This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM Fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.