August In Review: The Markets Just Don’t Care


.By Rob Edel, CFA

Highlights This Month

Read the monthly commentary in pdf format

 

Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 0.3 in the month of August.  The NWM Core Portfolio Fund 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.

Both Canadian and U.S. yield curves continued to flatten last month, though in Canada the flattening was entirely due to 10 year yields falling eight 8 basis points.  Short term rates were virtually unchanged resulting in a modest 0.3% increase for the NWM Bond Fund last month.

The NWM High Yield Bond Fund gained 0.4% in August, and is +3.6% year-to-date.  The top performing external manager last month was the Oaktree (25% of the Fund), returning +1.3% in USD’s.  The high yield market was generally strong in a quiet August, with the BofAML US High Yield Index returning +0.7% in USD, for a year-to-date return of +1.9%.  The NWM High Yield Bond Fund currently has 40% USD currency exposure.

The NWM Global Bond Fund was down -2.28% for the month as Templeton Global Bond returns detracted from overall performance.  Templeton was down about -3.9% as EM markets sold off, specifically, exposure in Brazil, Ukraine and Argentina were the largest contributors to negative returns.  Although Argentina is a small position at approximately 5%, it was down 37% for the month.  The weakness in the Argentine peso was driven by heightened risk aversion across emerging markets and specific speculative attacks.

Despite the sell-off, we remain confident in the outlook for Argentina and view the recent depreciations in the peso as an overreaction that should fundamentally reverse with time.  The IMF fully supports Argentina’s fiscal programs and has committed $50 billion.  Furthermore, Argentina has adequate levels of foreign reserves on top of the full support of the IMF, and the central bank made an immediate and appropriate response to the recent depreciation in the peso, hiking rates to 60% to bolster confidence that its inflation targets will be met.

EM markets are likely to continue to be volatile in the near future, however, given the significant sell-off we believe investors are more than compensated for taking Argentine risk as we remain positive on the longer-term investment potential in the local currency markets.

The Mortgage Pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.3% 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 4.4% for the NWM Primary Mortgage Fund and 5.4% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund had 7.7% cash at month end, while the NWM Balanced Mortgage Fund had 15.5%.

The NWM Preferred Share Fund returned 0.7% for the month while the BMO Laddered Preferred Share Index ETF returned 1.0%.  Flows into ETFs rebounded to $119 million, reflecting continued strong demand in the space.  News was mainly muted for the month as Canadian banks reported good earnings overall while S&P effectively upgraded the credit rating of BMO preferred shares citing historically low loan losses and increased diversity in revenue streams and loan exposures.

Canadian Equities were weak in August with the S&P/TSX -0.8%. The NWM Canadian Equity Income Fund was +0.7%.  The Materials sector was a large positive contributor, as the gold sector was very weak.  We also did well with our stock picking in Consumer Discretionary and Industrials.  This was offset by our positioning in Health Care (no marijuana) as the cannabis sector was very strong (Canopy +74%).  We were called away on Canadian Western Bank. There were no new additions.  Top contributors to performance were Air Canada, Cargojet, and Interfor.  Detractors were Teck, SNC Lavalin, and Canadian Natural Resources.  We are covered on 10% of the portfolio currently.  The yield estimate of the portfolio is 4.1%.

The NWM Canadian Tactical High Income Fund returned +1.7% in the month, beating the S&P/TSX’s -0.8% return.  The main reason for relative outperformance was due to being underweight the energy sector and stock picking (Air Canada & Gildan were both up over 10%).

Option volatility surged 19% the last few days of the month, but is still low from a historical perspective.  No new names were added during the month, but we did buy more IGM Financial, which has an attractive 6.29% dividend yield and cheap valuation.  We have been partially funding this trade by selling KP Tissue.

The NWM Global Equity Fund returned +0.7% vs +0.8% for the MSCI ACWI (all in CDN$).   The Fund underperformed the benchmark due being underweight the U.S. (one of the few markets that had a positive return in CDN$) and sector selection (underweight healthcare & Info Tech).  Performance of our managers in descending order was Edgepoint +3% (~64% in US & Japan), Lazard +0.8%, ValueInvest +0.5%, C Worldwide  +0.4%, BMO Asian Growth & Income -0.6% (large weight in HK/China >30%) and NWM EAFE Quant -1.3% (Industrials and German exposure detracted from performance).

The NWM U.S. Equity Income Fund returned +2.5% in August, underperforming the S&P500, which was up 3.3%.  We were underweight in Retail, which had a strong month, and overweight in Banks, which were flat.  Overall, stock selection was a drag on relative performance, as our position in Newell Brands and EOG, and not owning Amazon, hurt relative returns, while strong returns from our tech names, NVIDIA, Adobe and Visa; and healthcare stock HCA, partially offset relative returns.  Transactions during the month included adding a new position in Activision and the sale of US Bancorp.  Proceeds from the US Bancorp sale were allocated to our existing positions in other banks.

The NWM U.S. Tactical High Income Fund’s performance was -0.8% during the month; whereas, the S&P 500 posted a +3.3% return.  The NWM U.S. Tactical High Income Fund’s underperformance was mostly due to being underweight in Info Tech (2.6% weight vs 26.5% for S&P 500) and stock selection within an otherwise strong Consumer Discretionary sector (i.e. Delphi & L Brands).  Option volatility increased intra-month but ended the month close to where it was.  It is a challenging environment for the NWM U.S. Tactical High Income Fund as good quality stocks at cheap valuations and good option volatility are scarce.  No new names were added to the NWM U.S. Tactical High Income Fund this month.

The NWM Real Estate Fund was +0.3% for the month of August vs. the iShares (XRE) +2.5%. The Brookfield takeover of GGP closed on August 28.  We received shares of BPY-U as well as cash which we will use to fund our investment in Invesco Core Europe at the end of September. The residential REITs continue to outperform.  Morguard North American Residential REIT, Interrent, and Tricon were big outperformers this month.

The general consensus is that strong growth will continue in the residential asset class so we have been adding to our positions in this area.  Pure Multi-Family REIT was an underperformer this month.  Pure Multi-Family had been undergoing a strategic review, and while there was a lot of interest (24 NDAs), no agreement could be reached.  While it is a disappointing conclusion to the strategic review, the REIT is in good shape (high quality portfolio of garden-style multi-family apartments located in the US Sun Belt).  With strong fundamentals (SP NOI growth +5.7% in Q2), potential for further occupancy gains, and a fully covered 5.7% yield, we continue to like Pure and think that it is a buy.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of August 31st, July performance for SPIRE Real Estate LP was +0.6%, SPIRE U.S. LP +1.3% (in US$’s), and SPIRE Value Add LP +0.9%.

The NWM Alternative Strategies Fund returned 1.0% in August (these are estimates and can’t be confirmed until later in the month).  Without currency fluctuations, the NWM Alternative Strategies Fund would have been up 0.9% for the month as currency contributed 0.1%.  In local currency terms, Winton returned 0.8%, Millennium 1.3%, Apollo Offshore Credit Strategies Fund Ltd 0.4%, Verition International Multi-Strategy Fund Ltd 1.1%, RPIA Debt Opportunities 0.4%, and Polar Multi-Strategy Fund 0.5% for the month.

Winton returns were driven primarily by long bond positions and short positions in both silver and gold.  Detractors came from long positions in EM currencies including the Indian Rupee, South African Rand, and Russian Ruble. Arbitrage spreads have remained tight with low volatility and, as a result, managers such as Polar have reduced leverage and focused on more stable trades as they remain patient until more opportunities present themselves.

The NWM Precious Metals Fund returned -9.1% as precious metals stocks were materially lower for the month.  Gold bullion declined -1.8% in Canadian dollar terms for the month as the underperformance of precious metal stocks versus the bullion reverses a trend seen earlier in the year.  Gold weakened as the USD has continued to be surprisingly strong this year against the majority of global currencies.  Investors seeking the USD as a safe haven currency as fears mount for a global trade war coupled with expectations for rate hikes have further strengthened the USD and thus gold has suffered commensurately.

 

August in Review

U.S. stocks were higher last month, but as has been the case for most of the year, investors were less enthusiastic towards equities in other parts of the world, including Canada.  While the S&P 500 was up an impressive 3.3% (+3.7% in C$’s), the S&P/TSX fell 0.8% (in C$’s), despite the high flying cannabis stocks.  Chinese stocks fared even worse, with the Shanghai Composite down 5.1%, while European equities continued drifting lower, with the STOXX Europe 600 declining 2.1%, all in local currency terms.

The strength of the American market pushed U.S. stocks to some pretty impressive milestones last month.  Not only did the S&P 500 hit a new all-time high in August, recouping losses experienced during the January correction earlier in the year, but the current bull market, at 3,453 days and counting, became the longest-running rally for U.S. stocks on record.  Of course nothing is ever definitive when it comes to Wall Street and one first needs to determine how to measure a bull market before determining which one was the longest.  A bull market is commonly defined as a rally that extends beyond 20% without being interrupted by a decline of more than 20%.  Most believe the rally preceding the current record breaker, aka the dot-com bubble, started October 1990, following a 19.92% drop in the S&P 500.

If you’re a stickler and don’t believe 19.92% is close enough to 20%, then the dot-com bull market actually started much earlier, and at 4,494 days, is still the longest on record.  Others take exception to the start date used to measure the current bull market, March 9th, 2009, when the S&P 500 hit a 13 year low.  If you believe, as some skeptics do, a bull market only begins when a market exceeds a previous high, not when it reaches a bottom, the time clock on the current rally started on February 19th., 2013 when the S&P 500 exceeded its October 2007 high, not March 9th, 2009.  We are going to stop here.  You get the point.

A record bull market is all in the eye of the beholder, and who really cares anyway.  U.S. equities have had a good run and out-paced the rest of the world.  Who cares if it’s the longest bull market on record or not.

Monetary policy and the business cycle drive the market.

Conventional market wisdom holds bull markets don’t die of old age, meaning there is no best before date on the current rally.  They are not immortal either, however, and this one will eventually die.  Whether the end is near or not will largely depend on the business cycle, or more specifically monetary policy.  Where we are in the business cycle and how close it is to ending really is the elephant in the room and the main factor impacting markets globally.  We’ll touch on issues like trade wars and politics, mainly because they could have a bigger impact down the road, but our main focus again this month will be on monetary policy and the business cycle given this is what we believe is really driving the market.

The U.S. economy looks to have finally turned the corner.  While GDP growth might slow from the second quarter’s 4.1% pace, the benefits from corporate tax reform should continue to pay dividends for the next several quarters as companies finally begin to spend money again.  The spoils have already started to trickle down to the consumer, with applications for unemployment benefits recently reaching a 49 year low and wage growth increasing nearly 3% in August.  With inflation already reaching the Federal Reserve’s 2% target, price increases could begin to become more of focus for investors over the coming months.

While we see inflation continuing to firm, we don’t see it moving materially higher, at least not yet.  We do believe, however, present conditions give the Federal Reserve the green light to continue normalizing monetary policy and push overnight interest rates higher.   This shouldn’t concern investors.  Short term rates have been maintained at crisis levels for an extended period of time and the economy is no longer in crisis mode.  The Fed has learned keeping rates too low for too long can create financial bubbles, and besides, they need to start preparing for the next recession.  If rates stay too low, the Fed won’t have enough room to cut rates in order to stimulate the economy in the next economic downturn.

Strangely, however, longer term bond yields haven’t kept up with the move upwards in short term yields, and as a result the yield curve has flattened.  A flat yield curve is not necessarily a bad thing, but an inverted curve is and has historically been a near perfect signal the business cycle is coming to an end.  The market has historically used the two year versus 10 year spread as its benchmark for the slope of the yield curve, which at the end of August was a miniscule +23 basis points (+0.23%).  A recent research paper written by the San Francisco Federal Reserve makes the case the three month versus the 10 year spread has been a better predictor, which at nearly +80 basis points at the end of last month conveniently gives the Fed a little more breathing room to continue to move rates higher.

Theories vary on why 10 year yields have defied the experts and remained around the 3% level.  Foreign buyers and pension fund purchases are generally cited as common causes, but the fact remains current levels indicate investors are attributing very little risk to inflation moving higher over the coming years.  Hedge funds still believe yields are going to go up, and have taken large short positions in the 10 year treasury.  While this should be somewhat comforting, hedge funds and economists have been consistently overly optimistic over the years when it comes to 10 year yields.  If they are again proven wrong and are forced to cover their short positions quickly, yields could fall even more (strong demand or buying will cause prices to rise and yields to fall).

Interestingly, while the U.S. yield curve gets most of the attention, the Canadian yield curve as measured by the two year versus 10 year spread is even flatter, having shrunk to less than 20 basis points.  Fortunately, the three month versus 10 year spread is a more comfortable 70 basis points or so.  Like the Fed., the Bank of Canada is also looking to raise overnight rates so an inversion of the Canadian yield curve could also be in the offering.

While Canadian GDP growth and employment growth have lagged that of the US, wage growth and inflation in general have trended higher.  Also, there is a strong positive correlation between the Canadian and US economy so we would expect Canada to benefit from continued growth in the U.S. economy.  This should eventually translate into higher equity returns as well, though the composition of the Canadian market is less diversified than the broader U.S. market.

The technology sector, for example, has been a major driver of returns for U.S. stocks, but is barely represented at all in the Canadian S&P/TSX index.  One caveat for the Canadian economy, however, Canadians have racked up a lot of consumer debt (mostly mortgage related) and it’s debatable how much interest rates can rise before consumer spending falls off a cliff.  We also suspect the construction industry in Canada has grown such that it represents a larger than normal percentage of the Canadian economy.  Its eventual reversion to the mean will be a headwind for future GDP growth and could limit the Bank of Canada plans to continue to raise overnight interest rates.

Will the Federal Reserve (and the Bank of Canada) continue to raise interest rates, even if it means the yield curve inverts?  It’s going to be a close call.  The Fed is on track to raise two more times this year, in September and December.  If 10 year rates haven’t moved higher by then, it’s likely the yield curve will be inverted.  The Fed wants to keep raising rates and the strength of the economy would indicate that they should, but the bond market is telling them to stop.

Echoing this call are emerging market economies and anyone who is hurt by a strong U.S. dollar.  While the U.S. economy has been strengthening, global growth has not followed suit. Recent trends indicate some hope global growth might again start converging upwards towards that of the U.S. with positive economic surprises becoming more prevalent, but it’s too early to call the turn.

Diverging growth is positive for the US dollar as it means the U.S. is likely to remain one of the few countries in the world raising rates.  Even when fears of trade wars hit global markets, the Greenback strengthened, as it is seen as a safe haven currency, despite the fact America is at the epicenter of the trade war threat.

Even traditional safe haven asset gold has wilted under the shadow of the US dollar rally.  Most commodities suffer when the dollar moves higher (commodities are priced in US dollars so all things being equal, commodity prices move lower to compensate for a stronger dollar) but gold’s recent correction has been particularly painful.

A stronger dollar isn’t such a bad thing, and in fact should be expected in a properly functioning global economy where one country is growing faster than others.  A country with a weaker currency should expect to benefit as their exports become cheaper and more competitive.  Where they run into problems, however, is if they have financed their growth with foreign capital denominated in a currency other than their own, namely U.S. dollars, and they now find the cost of servicing that debt has increased.

That is exactly what many emerging market economies have done and why these markets are under pressure.  It was cheaper to borrow in U.S. dollars rather than in their own currency, but now, not only is the dollar denominated interest payment more onerous; but the principal will become much more expensive to refinance.  Turkey and Argentina are the worst offenders and have taken the largest hit so far, but if the U.S. dollar continues to move higher, the contagion is likely to grow.  With the Federal Reserve tightening, the U.S. government running larger budget deficits, and American corporations repatriating dollars held offshore, spare greenbacks could be harder and harder to find.

Even emerging market countries like Indonesia, which according to Nomura Securities has public debt of only 29% of GDP and short term foreign debt equivalent to only 27% of its exports, is looking vulnerable.  Indonesia isn’t Turkey or Argentina.  Yes they have a growing trade deficit and a lot of foreign debt, but they have also been playing ball by raising interest rates and cutting spending.  They are trying to do the right thing, and yet the Indonesian rupiah has fallen 10% against the dollar this year.

Markets don’t care about all-out global trade war.

So far, U.S. markets haven’t been impacted by the turmoil in the emerging markets.  As Nixon era Treasury Secretary John Connally was famously quoted “the dollar is our currency, but your problem”.  At some point, however, the contagion will hit North American markets.  Developed market financial institutions and investors with emerging market assets (Banks with outstanding emerging market corporate loans and investors holding emerging market stocks and bonds) will feel the pain.  The global economy is too integrated for it not to impact the developed world at least to some degree.  We’re actually surprised how little markets appear to care so far.  Same goes for the threat of an all-out global trade war.

Last month, the U.S. reached a tentative unilateral trade agreement with Mexico, which it is using as leverage to force Canada into agreeing to a new trilateral NAFTA deal.  The Americans, and President Trump in particular, have put our Prime Minister in a tough spot politically, with a very tight negotiating timeline and little to no room to negotiate.  In off the record comments to Bloomberg, President Trump stated a new agreement would be “totally on our terms”.  Take that Justin!  As painful as it may be for Canada, Trudeau appears willing to walk away from a deal if some form of the old Chapter 19 dispute resolution mechanism isn’t maintained.

Dairy supply management and cultural exemptions are also sticking points in the negotiations, but probably not deal killers.  President Trump has threatened Canada with auto tariffs if Canada doesn’t agree to terms, but the Donald might be overplaying his hand a bit.  Any new deal would likely require approval from Congress, and it’s not certain Congress would give the green light to any deal that doesn’t include Canada.

According to the Chicago Council on Global Affairs, American, public opinion towards NAFTA has become more favorable over the past year and Pew Research survey’s show 67% of Americans harbor warm feeling towards Canada, while the other 23% had never hear of us (just kidding).  Common sense tells us a deal will get done and the U.S. is just using hard ball negotiating tactics, but stranger things have happen during the Trump administration.

No quick resolutions to U.S. and China trade issues.

Logically, China would still appear to be the real target.  American trade negotiators would like to wrap up deals with Canada, Mexico, and Europe so they can concentrate their efforts on China.  Trump is threatening 25% tariffs on an additional $200 billion of Chinese imports (the U.S. has already announced 25% tariffs on $50 billion of Chinese imports), which China has promised to counter with tariffs on $60 billion of U.S. exports.  Trump is playing hard ball, just like he did with Europe, Mexico, and now Canada.

The stock market is telling him he is winning, given the S&P 500 continues to move higher while the Shanghai composite has entered bear market territory.  The problem is everyone is on to the Donald’s antics and tactics.  His book, “The Art of the Deal” is probably on the nightstand of every world leader.  No political leader with an eye to maintaining their grip on power can afford to be seen as having been out maneuvered by The Donald.  Don’t expect a quick resolution to the China trade issue problem.  It could drag on for months/years and its economic impact is likely underappreciated by the market.

Chinese leaders are known for focusing on the long game, and waiting out Trump is looking to be a very attractive option.  According to a Washington Post/ABC News poll, President Trump’s approval rating fell to 36% in early September, with support amongst Republican’s falling to 76% from 83% the previous month, and this is with a strong economy!

Global economy unsteady as a result of U.S. politics.

According to Bloomberg, Trump is the only President in recent history to see his approval rating lag economic sentiment.  President Trump is likely to see his support fall even further following the release of two damaging stories detailing life inside the White House.  Bob Woodward’s new book, “Fear – Trump in the White House”, chronicles a number of disturbing tales of Trump’s time in office as told by those working with and for him, and excerpts from the book were made public in early September, before the official release date of September 11th.

Perhaps in response to the Woodward’s book, a senior official in the Trump administration wrote an anonymous essay published in the New York Times claiming to be part of the “resistance” in the Trump Administration.  The writer appeared to try and reassure the public that they were “adults in the room” working to “frustrate parts of his (Trump’s) agenda and his worst inclinations”.  Comforting on some levels, but not exactly the ideal democracy most Americans thought existed.  And yet, the markets don’t seem to care.

Investors appear to be very complacent.  Valuations are high and strategists’ appear to be lifting year end estimates for U.S. stocks in line with the current rally.  The consensus on Wall Street remains focused on the strong economy and higher corporate earnings, and not higher interest rates, the threat of trade wars, and a dysfunctional White House.  The consensus is probably right, for now, but likely underpricing the risk if U.S. and global markets begin to converge.  Either global growth accelerates and matches that of the U.S., or tighter monetary conditions will slow U.S. growth back down to global trend lines.

The dollar can’t keep going up without something or someone breaking.  Stronger global growth might be negative for U.S. markets from a relative perspective, but positive for absolute returns.  Slower U.S. growth and corporate earnings, not so much.  The end of the current business cycle should be in the minds of all investors.  While we don’t think we are there yet, the yield curve is telling us that we continue to move closer and closer.  And then what?  The anonymous “Resistance” within the White House talk about the good things Trump has accomplished, like tax cuts and deregulation.

The results are evident in the strong economy.  But they have also resulted in an increase in government debt that will increase even more during the next recession.  It’s possible all that Trump has accomplished is to bring us to the end of the economic cycle faster and made dealing with the next recession harder.  Look out if this becomes the consensus.

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 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. Please speak to your NWM advisor for advice based on your unique circumstances. NWM 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. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.