Big Trouble in Slowing China - Nicola Wealth

Big Trouble in Slowing China


Highlights This Month

NWM Asset Class Highlights

It was a risk on month in July with equity assets trading higher and fixed income products recouping some of their losses from last month.

Most of the gains in fixed income were derived from credit or coupon return as yields on short-term government bonds. Bond yields moved only slightly lower.

Yields on 2-year Canada’s declined from 1.22% at the end of June to 1.16% at the end of July.  10-year Canada’s even backed up, with rates at the end of July hitting 2.45% versus 2.44% at the beginning of the month.

The NWM Bond Fund was up 0.7% as our recent allocations to alternative investment grade managers Eastcoast, Merrit, and RP, tend to carry more credit risk.

Credit risk also helped high yield bond returns in July, with the NWM High Yield Bond Fund increasing 1.2%.

Global bonds didn’t fare as well, with the NWM Global Bond Fund declining 1.5%.  Keep in mind, however, the Canadian dollar appreciated 2.3% versus the U.S. dollar during the month, so this was actually a pretty good result.

Mortgages continue to provide consistently positive returns, with the NWM Primary Mortgage and the NWM Balanced Mortgage returning 0.5% and 0.8% respectively.

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 unchanged from last month at 4.5% for the Primary fund and 7.0% for the Balanced.

Preferred shares were weak again in July with the iShares Preferred Index ETF down 1.2% and the BMO Laddered Preferred Share Index ETF lost 1.5%.  By comparison, the NWM Preferred Share Fund delivered a strong relative -0.6% return.

We continue to see value in purchasing mid- and low-rate resets shortly before they are extended by the banks and converting them into the floating version.

Converting rate resets into their floating counterparties will allow us to efficiently transition the fund into a lower duration portfolio without going to the market and paying a premium price for taking liquidity.

Canadian equities were stronger in July with the S&P/TSX gaining 3.2% (total return, including dividends), while the Strategic Income Fund was up 3.1% and the NWM Canadian Tactical High Income Fund was up 3.1%.

Foreign equities were also stronger in July with NWM Global Equity Fund up 2.4% versus 2.9% for the MSCI All World Index and 2.7% for the S&P 500.  All our external managers were up except Guardian Asia Growth and Income, which was down 0.8%.

The NWM U.S. Tactical High Income Fund returned 3.5%, held 17% cash, and a projected current yield of about 9.2%.

The REIT market continued to come under pressure in July with the NWM Real Estate Fund down 1.9%.

The alternative strategies funds were mixed again in July, though it was gold that was providing support for a change.  Gold bullion rallied over $60 in July, increasing just under 5%.  Gold stocks were up even more, with the NWM Precious Metals Fund gaining 9%.

With continued speculation of “tapering” by the Fed, expect gold to continue to be volatile.  The NWM Alternative Strategies Fund was down 2.3%, as trend-following strategies continue to frustrate investors.

July In Review

By Rob Edel, CFA

Equity markets shook off concerns of Fed “tapering” (reduced bond purchasing by the central bank) and posted strong gains in July with the S&P 500 and the Dow Jones Industrial Average up 5.1% and 4.1% respectively.

Investors appear to be more preoccupied with enjoying the summer than worrying about potential problems brewing in the capital markets and around the world.

Even the city of Detroit filing for federal bankruptcy – the largest ever municipal default – didn’t seem to worry the markets.

MMC-2013-07-Detroits newest model

Historically, stocks perform poorly during the summer months and a strategy of “sell in May and go away (until St. Ledger’s day)” is usually a profitable one.

Since 1957, when the S&P 500 was first introduced, buying on the last day of April and selling at the end of September would have yielded investors a paltry 0.5%.  Alternatively, buying at the end of September and holding until the end of April has netted an annualized 7%.

To be fair, this isn’t the first year the S&P 500 has hit new highs in July.  In fact, over the S&P 500’s 56 year history, it has managed to log new July highs 25 times.

Even better, in the 25 years this has happened, the S&P 500 has managed to deliver average returns for the year of 16.9% versus a very mediocre 1.4% for years in which it didn’t hit new highs in July.

Sometimes it pays to stick around for the summer.  Let’s call it an investor staycation.

MMC-2013-07-Stay vacation

Clearly investors continue to see some positive signs of growth coming from the U.S economy.

Yes, the growth is probably strong enough to convince the Fed to reduce their monthly bond buying program, most likely starting in September, but not strong enough to compel the Fed to start raising interest rates anytime soon.

While the performance of U.S. equities has been strong, there are some underlying trends in the market that has us a little concerned.

According to the Investment Company Institute, investors ploughed $7 billion back into stocks during the first two weeks of July after having sold an estimated $6.3-billion in June.

What is more interesting, however, is money market funds are attracting the most attention, with $8.5-billion flowing into cash for the week ending July 17th alone.

Investors continue to shift out of bonds, but they are not yet willing to invest heavily into stocks, despite the good run in performance.

MMC-2013-07-Cashing out

Another troubling characteristic of this rally is that when investors are willing to buy equities, they have tended to concentrate their purchases in companies exposed to the domestic U.S. economy, such as consumer discretionary and small cap stocks.

Consumer discretionary stocks have been the best performing sector in the S&P 500 this year and small cap index, the Russell 2000, is up more than 30% over the past 12 months versus a 22% increase for the big cap S&P 500.

We think growth in the domestic U.S. economy is getting stronger, but it is by no means strong.

MMC-2013-07-Small stocks big gains

Finally, valuations are starting to get a little stretched.  Trading at 14.5 times expected earnings, the S&P 500 is slightly above its 10-year average of 14.2 times and is at its highest level since September 2009.

While the S&P 500 is still below the 16.6 times average since 1988, this period includes the high flying dot-com era, when valuations commonly exceeded 20 times forward earnings.  That’s assuming the companies actually had earnings.

Presently, the consumer discretionary sector is trading at 17.5 times forward earning, above its 10-year average of 16.3 and well above the S&P 500 at 14.2 times.

Small caps are even more expensive, with the Russell 2000 trading at 18.3 times forward earnings compared to its average since 1979 of 14.9.  Valuations might prove to be even higher if earnings don’t increase as expected.

With corporate profit margins approaching historical highs, earning growth is likely to slow.  In four of the past five quarters, revenue growth for the S&P 500 grew more slowly than the U.S. economy, which itself barely grew.

If profit margins start to slide back to normalized levels, earnings growth could stall and the market might not be as cheap as it appears. Wall Street has been on a great run, but don’t pop those champagne corks just yet.

MMC-2013-07-The-End-of-the-Beginning

In order for us to have confidence that the current equity market rally is sustainable, we need to see the breadth of the market increase beyond U.S. domestic consumer cyclicals and small cap stocks.

The S&P/TSX did its part in July, finally, returning 3.2%, which is pretty strong when one considers the Canadian dollar was up over 2% in July.

Yes, the S&P 500 was up 5.1% in local (USD) currency terms, but in Canadian dollar terms it was up only 2.7%.  This is a welcome relief as Canadian stocks have trailed their U.S. counterparts for most of the year and were actually in the red until July.

Not all markets were as strong, however.  The Shanghai Composite was down 0.7% in Canadian dollars, as concerns over a slowing Chinese economic growth continue to hit the headlines.

In fact, Merrill Lynch’s July Fund Manager Survey identified a Chinese hard landing as the number one concern for investors.

MMC-2013-07-What do you consider the biggest tail risk

Economic growth in China has declined and most fund managers expect it to continue to slow.

Officially, China GDP growth slowed to 7.5% in Q2 versus 7.7% in Q1.  The official purchasing manager’s index in July came in at 50.3 – just above 50, thus indicating the manufacturing sector is expanding, but just barely.

In addition, the exports sector shrank 3.1% in June, the first non-holiday contraction since November 2009.

MMC-2013-07-Different strokes

But these are just the official numbers.  Many feel the real numbers are worse.

While the official Chinese purchasing managers index show China barely growing, the HSBC Purchasing Managers Index plunged well into contraction territory last month.

The HSBC index represents mainly smaller exporters and excludes larger state-owned enterprises.  This could account for some of the difference between the two indexes, but many economists have questioned China’s economic reporting for years.

Variability in Chinese GDP growth has historically been very smooth.  Unusually so, in fact.

China releases their annual GDP numbers in the third week of January and only revises them the following year.  How can they report so quickly?

In 2007, current premier Li Keqiang described the Chinese GDP data as man-made and for reference only (thank you, Wikileaks).  Mr. Li suggested electricity use, freight, and credit growth were better proxies for economic growth.

Analysts have compiled a “Li Keqiang Index” using these indicators and estimate growth has cratered to less than 2%.

Another hard-to-manipulate statistic is exports to China as compiled by other countries.  Over the past 12 months through May, the sum of these exports was down 4.9% year-over-year.

MMC-2013-07-Exports to China

Fear not, however, China recently indicated that their line in the sand for economic growth is 7% (which should be easy to achieve if it is true that they just make it up).

Most economists haven’t been too concerned with slowing Chinese growth, because it was always assumed China has ample financial flexibility to stimulate the economy through investment spending.

Problem is, China is now getting less bang for their investment spending buck.

Since the early 1990’s, the IMF estimates China’s return on investment has fallen by about 30% and Fitch Rating Inc. believes every Yuan invested produces only a third of the return in economic growth it did before 2009.

I mean there are only so many six lane bridges to nowhere one needs.

In contrast to other Asian economies during their years of strong economic growth, China’s investment levels have failed to level off.

China realizes it needs to re-balance its economy.  In the first half of 2013, consumption accounted for only 45.2% of GDP versus 51.8% in 2012.  It’s over 60% in most industrialized countries and around 70% in the U.S.

Unfortunately, slower growth may be part of the solution.  Don’t get too bearish, though, China has a number of things working in their favour.

Foreign debt is a relatively low 10% of GDP and the national savings rate is over 50% of GDP.  China also has ample foreign exchange reserves and still has a relatively low urbanization ratio.

An estimated 250 million people are expected to migrate from rural to urban areas over the next 20 years.  Since city dwellers typically out-earn their rural counterparts, consumption should naturally move higher.  It’s just not going to happen overnight.

Keep your eye on China.  It has the potential to overshadow the positive growth we are seeing in the U.S. domestic economy.

MMC-2013-07-Diminishing returns

Could Europe make up for slower Chinese growth?  Unlikely, but perhaps we have seen the worst.

Unemployment in the 27-member European Union fell to 10.9% in June from 11% in May – the first decline in two and a half years.

Markit’s composite purchasing manager index for the 17-nation Euro-zone rose above 50, thus indicating the manufacturing sector could be growing for the first time since January 2012.

The European Commission’s economic sentiment index, which includes both households and businesses, increased to its highest level since April 2012.

Consumer confidence in the Euro-zone increased to -17.4 in July versus -18.8 in June, the highest level since August 2011 and eighth month-over-month increase in a row.  Never mind that the average since 1990 has been -13.3, at least it’s headed in the right direction.

The European Commission estimates the 27-nation European Union will emerge from recession in the fourth quarter of this year and grow 1.4% next year.  The Commission expects the 17-nation Euro-zone will expand 1.2% next year.

It appears the worst is over for Europe.

MMC-2013-07-Rosier outlook

At least it is until September 22nd

This is Election Day in Germany and government officials dare not let anything derail Chancellor Merkel’s re-election bid.  Any problems brewing in Europe will be kept under wraps until then.

And problems there are.

10-year Portuguese bond yields spiked higher in July as the government threatened to collapse.

Spain’s government has recently been entangled in a slush-fund scandal and Premier Rajoy is under pressure to resign.

A leaked report from the European Commission questions Greece’s “willingness and capacity” to collect taxes.  It’s a miracle that Greece’s coalition government hasn’t already collapsed.

Same with Italy’s. S&P downgraded Italy’s debt rating to near junk status, pointing out that near-zero real GDP growth means Italy will need to run a primary surplus of 5% of GDP in order to stabilize its debt-to-GDP ratio.

And this is the real problem for Europe, debt levels continue to grow and austerity is not helping create economic growth.  Yes, maybe the recession is over, but slow economic growth is not enough to stabilize debt levels in Spain, Italy, Portugal and Greece.

What is the long term solution?  You ain’t going to find out until after September 22nd.

MMC-2013-07-Conditions in Europe have stopped worsening

In order for equities to continue to move higher, the U.S. economy is going to need some help from China and Europe.

Unless the current rally broadens to include companies with global sales and exposure to cyclical sectors of the global economy, we question how durable it will be.

The U.S. Economy

MMC-2013-07-Economic Growth-Table-US

Second quarter GDP growth came in better than expected, but then expectations were pretty low.  Also, more than 24% of the growth came from higher inventories, which is unlikely to be sustainable.

Consumer spending increased 1.8% (down slightly from last quarter’s 2.3% increase), with big-ticket purchases such as autos continuing to out-pace most other items.  Also adding strength was housing, up a strong 13.4%.

Federal government spending was predictably down 1.5%, but well off declines of 8.4% in Q1 and 13.9% in Q4 of last year.  State and local government spending was actually higher, giving hope that fiscal drag will become less of a factor in the second half of the year.

Not a strong quarter, but moving in the right direction.

MMC-2013-07-Second-Quarter GDP

MMC-2013-07-Employment-Table-US

Also making slow, but steady progress is the employment market. A disappointing 162,000 jobs were created in July, but the unemployment rate fell to 7.4%.

Slowly, but surely, the unemployment rate is getting closer to 6.5%, the Fed’s target level for beginning to raise interest rates.

This goldilocks scenario is just what the markets ordered.  The unemployment rate is coming down, but not quick enough to force the Fed to increase interest rates anytime soon.

Hours worked and wages also declined slightly, indicating there is still a fair bit of slack in the job market.

MMC-2013-07-Job growth is slower

MMC-2013-07-Inflation-Table-US

Headline PPI was high due to stronger energy prices.  Core inflation remains well under control.

MMC-2013-07-Consumer Confidence-Table-US

Conference Board consumer confidence was down slightly in July, but still well off lows hit earlier in the year.  The University of Michigan Consumer Sentiment Index hit its highest level since July 2007.

MMC-2013-07-Consumer confidence

MMC-2013-07-The Consumer-Table-US

Retail sales in June came in below expectations and only increased from May levels due to higher auto sales.  This is disappointing given gas prices were higher, thus indicating retail sales excluding autos actually contracted.

July sales are also looking a little light as consumers get a late start on back to school shopping.  A recent survey by the National Retail Federation estimates back to school spending this year will fall to $634.78 for a person with school age children versus $688.62 last year.

Average consumer credit confirms this weakness as revolving credit (credit cards) actually declined $2.7 billion in June.  This is counter to what we would expect given the strong consumer sentiment numbers.

Tax increases earlier in the year are most likely to blame and should moderate in the second half of the year.

MMC-2013-07-Housing-Table-US

The housing market has been a bastion of strength for the U.S. economy, and while we don’t see that changing over the near term, there are some potential dark clouds worth keeping our eye on.

The inventory of existing homes available for sale is presently only 5.2 months (meaning it would take 5.2 months to sell all the homes presently for sale based on the current pace of sales) versus about 6 months for a balanced market.

Markets such as Phoenix, Seattle, Denver, and Sacramento had less than a 2.5 month supply.  The inventory for new homes is a shocking 3.9 months. This is good in that it should lead to increasing housing starts and thus increased economic activity.  It’s bad because it is helping to drive prices higher.

Also a concern is mortgage rates, which jumped a full percentage point over the past couple of months; this hasn’t happened since 1994.  Economists believe mortgage rates could jump another 1.5% before home prices would become unaffordable relative to historical levels.

Regardless, we did see existing home sales decline slightly in June, as well as pending sales.

MMC-2013-07-Market Forces

We still think the housing market recovery still has legs, but we need the rest of the economy to continue to recover, particularly the youth job market.

First-time buyers drive the housing market and over the past 30 years have accounted for 40% of home sales.  They are also the most price sensitive, however, and have been the hardest hit in terms of unemployment.

If the housing market is to continue to recover, first-time buyers are going to need to step up.

MMC-2013-07-Shrunken Share

MMC-2013-07-Trade-Table-US

The U.S. trade deficit narrowed in June to its smallest gap in four years as U.S. exports surged to their highest level on record.

The main drivers were increased demand for American industrial supplies (such as aircraft) as well as stronger sales of consumer goods.

Lower imports could be a negative signal regarding the strength of the domestic U.S. economy, especially given the largest decline was in consumer goods.

Regardless, the strength in exports and the decline in the trade deficit bode well for the Q2 GDP and could result in positive revisions.

MMC-2013-07-Looking Up

We still think the U.S. economy will continue to grow, but slowly.  Overall, we saw a little more weakness last month than in previous months.

The Canadian Economy

MMC-2013-07-Economic Growth-Table-CAD

Canadian GDP growth in May was strong, buoyed by good retail sales activity, particularly in auto and auto parts.

Brace yourself for June, however, as floods in Alberta and Toronto and a construction strike in Quebec will hurt growth, with many expecting up to a 0.5% contraction in GDP.

The slide in the Ivey Purchasing Managers Index in July is an early indicator of the decline expected, though it should be pointed out its sample size is quite small, making it prone to wide swings.  It is also not broken out by region.

Another factor with the potential to weigh on future growth could be lower Potash prices, which, as an industry, accounts for about 0.5% of Canadian GDP.  Regardless, the weakness in the Canadian economy is expected to be short lived as a stronger U.S. economy should bring Canada along for the ride.

MMC-2013-07-Ivey Purchasing Managers Index

MMC-2013-07-Employment-Table-CAD

Not a good month for Canadian job hunters in July with nearly 40,000 jobs disappearing and the unemployment rate increasing to 7.2%.   Over the last six months, Canada has created an average 11,000 jobs, down from an average of 27,000 the previous six months.

All the weakness in July came from the public sector, which shed 74,000 positions, with the health care sector contributing 47,000 of these.  We have to admit, we question the accuracy of this as we don’t see the cause of a reduction in health care jobs.

Workers aged 15-24 years of age also lost out, losing 46,000 jobs. Optimistically, the Organization for Economic Co-operation and Development is projecting Canada’s unemployment rate will fall to 6.7% next year.

Granted, they made this forecast before July’s numbers were released.  The OECD also warned Canada’s long-term unemployed have not fared as well and pointed to young workers with low skills as experiencing unemployment rates of 13.8% as a group and in need of targeted aid.

MMC-2013-07-Inflation-Table-CAD

Inflation continues to be a non-issue in Canada.

MMC-2013-07-Consumer Confidence-Table-CAD

MMC-2013-07-The Consumer-Table-CAD

Retail sales in May increased at their fastest pace in three years, led by brisk sales of motor vehicles and parts.

Also helping results were higher gas prices and stronger building material and garden equipment sales.  Sales at appliance and electronics stores declined slightly.  Consumer confidence was slightly lower, but not enough to dent prospects for coming months.

Unfortunately, more spending means more debt.  A recent Bank of Montreal study found 83% of Canadians have some form of debt, an increase from last year’s 74% total.

It also appears Canadians are managing to take on more debt by reducing their monthly payments.  Last year, Canadians repaid an average of $1,133 per month versus only $986 this year.

Mortgage debt comprised 34% of total debt, followed by car loans and student loans at 19% and 14% respectively.

MMC-2013-07-Housing-Table-CAD

The Canadian housing market continues to be headed for a soft landing.  Existing home sales in June were down only marginally versus last year and were actually up from May’s total.

Prices were slightly lower versus May, but up nearly 5% compared to last year.  The inventory of homes available for sale remains a healthy 6.1 months.

Even Toronto and Vancouver look to be in good shape as both markets experienced record sales in July.  Greater Vancouver posted a 40.4% increase versus last year’s depressed levels, while Toronto posted a 16% increase.

Sales in Vancouver were also up 11.5% over June and 0.1% above the average July over the past ten years.  Prices in Vancouver were down 2.3% versus last July, but have increased 2.3% over the past six months.

Perhaps in response to the recent strength in the housing market, the Canada Mortgage and Housing Corporation announced plans in early August to limit the guarantee it offers lenders on mortgage-backed securities.

According to National bank analyst Peter Routledge, the new limits could result in mortgage rates increasing 20 to 65 basis points.  Housing starts and permits have already started to decline in Canada, which is a good thing.

TD economists estimate there is an over-supply of 250,000 homes likely to hit the market over the new two years and Capital Economics warns residential investment as a share of GDP could detract 0.5% from GDP next year as housing starts continue to decline to compensate.

Perhaps, but so far the soft landing scenario is playing out nicely.

MMC-2013-07-Trade-Table-CAD

Stronger exports helped narrow Canada’s trade deficit in June, led by metal and non-metallic mineral products.

A stronger U.S. economy is the best thing the Canadian economy has going for it.  The slowing housing market will continue to weigh on growth, but a soft landing should mitigate the damage.

What did you think of June’s market 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 fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.