Given strong investment returns last year, and the fact we are starting 2018 off at high historical valuations in most asset classes, we asked each of our major asset class managers to comment on their outlook for returns and strategies they plan to utilize in what could become an increasingly tough environment in which to generate positive investment returns.
Investment markets continue to benefit from the synchronized global economic recovery that started in the U.S., but has been joined by other economies, both developed and emerging. According to the International Monetary Fund, in fact, only six out of a total of 192 countries are expected to be in recession in 2018, the fewest on record. With the duration of current economic recovery exceeding eight years and counting, it is one of the longest on record and equities prices have appreciated accordingly. The current bull market for the S&P 500 is the second longest in the post-WWII era and valuations based on cyclically adjusted earnings have moved to levels exceeded only during the tech bubble of the early 2000’s. With interest rates and bond yields at historic lows, however, fixed income valuations look even higher than equities.
Against this backdrop, investment strategy has become challenged. All asset classes remain expensive, and though the current economic environment remains constructive, the duration of the current expansion phase brings in question how late in the cycle we are. Recessions and bear markets have historically gone side by side.
With valuations of all asset classes starting from such high levels and some degree of reversion to the mean expected at some point, investors can anticipate investment returns to be lower over the longer term. The timing of a bear market in any asset class, however, is very hard to predict, and while we believe valuation will mean revert over the long term, this doesn’t mean returns can’t continue to move higher in the near term.
One of the best indicators for the economy is the shape or slope of the yield curve, specifically the spread between 10-year and 2-year treasuries. Of the five U.S. economic recessions since the mid-1970’s, all have been preceded by an inversion in the yield curve. While the yield curve has flattened in 2017, it remains positive. Historically, the yield curve has provided investors with an early warning signal; with stocks averaging in excess of a 15% return during
the 17 months (also an average) between when the yield curve inverts and the start of the bear market.
We are closely watching inflation and its impact on central bank monetary policy. Based on current trends, we see gradually increasing inflation to result in interest rates slowly trending higher as global growth continues to recover. This is a good environment for most risk assets, with earnings growth taking over from valuation gains in providing investor returns. As the business cycle matures and monetary policy becomes more restrictive, we would expect volatility to increase as investors begin positioning their portfolios more defensively.
While we will comment more on strategies being employed in specific asset classes below, there are some themes common to the management of all our funds. From an investment strategy perspective, while we would look to use market volatility as an opportunity to re-balance portfolios, we are not expecting to make any large tactical asset mix changes to client portfolios.
Our investment philosophy is based on diversification and defensive cash flow investing, not market timing. Most of our short-term positioning and strategy takes place within our funds rather than changes in the mix of our funds. Using a combination of internal and external expertise, our goal is to add value through cost-effective active management. Asset classes where we have internal expertise will be managed by NWM portfolio managers, while we will use the buying power of our pooled funds to negotiate institutional pricing from world class managers in other asset classes.
Our expectation of gradually higher interest rates presents a unique challenge from an investment perspective. Fixed income, equity, and real estate valuations have benefited from the 30-year trend of declining interest rates and ultra-accommodative monetary policy being employed by central banks since the financial crisis. Interest rates and liquidity will come under pressure as central banks begin to unwind their bloated balance sheets, leaving the capital markets to pick up the slack. In anticipation of this event, we have tried to reduce our interest rate risk as much as possible in all asset classes. With valuations high and volatility set to increase as interest rates move higher, we believe active management will once again become more important in generating returns.
We worry about position concentration with passive investing, particularly as we get closer to the end of the current bull market. One area we expect to continue to generate superior risk-adjusted returns is in the private marketplace. While we are cognizant of the increase in valuation here as well, trading off liquidity for higher returns can provide investors higher risk-adjusted returns if structured correctly.
We also believe investors have to be willing to look beyond Canada for opportunities. Canada is a relatively small economy, and while we believe Canada’s integration with the U.S. economy and our overall positive outlook on U.S. economic growth should result in positive growth for Canada, the narrowness and sector concentration of our economy limits the investment opportunities and increases risk.
Although we believe that the cycle is getting long in the tooth, market conditions continue to be supportive of equity markets. Interest rates are at very low levels, inflation is under control, and now the House and Senate Republicans have come to a preliminary final agreement on their compromise tax bill. The compromise bill proposes cutting the corporate tax rate to 21% (from the current 35%) and the top individual tax rate to 37% (from 40%). As a result, earnings growth in the US is expected to accelerate this year into the high single digits. Again, this is a good environment for equity markets. Job growth is strong and we expect labor conditions to continue to tighten. Overall, we would be well positioned for a continuation of the “slow growth and slowly rising interest rate” environment. We also expect volatility to pick up.
The equity markets are modestly overvalued so we expect valuations to stagnate. In other words, given somewhat stretched valuation levels, it will be tough for private equity (PE) to expand meaningfully. Keep in mind that valuation metrics looks better when you take the high flying Facebook, Amazon, Netflix, and Google (FANG) stocks out of the equation. Regarding FANG stocks, we choose to be selective in this area. We need to see evidence that the business model is profitable and prefer the utility-like search vs. social media. We see risks in the amount of money that investors have poured into ETF products over the past few years. As more money has gone into passive ETFs, the price of the stocks (and bonds) that make up the indices being bought rises. The danger of a liquidity squeeze when the market comes under pressure is what we worry about.
Overall, our style of investing across our equity mandates is value-tilted with less of an emphasis on owning what the index owns. As a result, our style lends itself to outperform in down markets. Currently, the NWM Canadian and U.S. Equity Income Funds are underweight interest rate sensitive sectors (telecom and utilities) as these sectors tend to lag in a rising interest rate environment. Likewise, the funds are overweight financials which should benefit as the general level of interest rates rise.
We continue to like covered call and put writing as a strategy. Our equity funds generate significant cash-flow by investing in a combination of dividend-paying securities and further enhance the yield by covered call writing. The NWM U.S. and Canadian Tactical High Income Funds have been actively rotating out of companies that are trading expensive and/or have low option premiums and moving into quality names with clean balance sheets and higher option premiums. The NWM U.S. Tactical High Income Fund and the NWM Canadian Tactical High Income Fund have been defensive all year long and will continue to be defensive in terms of holding more liquidity than normal, fully covering long-only positions with call options, and/or writing put options farther outof-
the-money. Also, it should be noted that the NWM U.S. and Canadian Tactical High Income Funds with their use of option strategies currently have low equity equivalent exposure which should provide downside protection if there is a market correction. As of Q3 2017, correlations between sectors have broken down which is good from an active management perspective but we look forward to a pick-up in market volatility to earn higher premiums on our options strategies.
We view private equity as an attractive source of alpha for an investor’s equity exposure. While private equity valuations similarly are rising with public equities, particularly in the larger companies in the U.S., we continue to see value in the lower-middle market in Canada which is the core of our strategy. In the U.S., large mega-PE funds have seen valuation and leverage multiples expand; however in the Canadian lower-middle market, purchase and leverage multiples are lower versus the U.S. and still look reasonable. The NWM Private Equity Limited Partnership will deploy capital through the cycle to benefit from vintage diversification (i.e. the Fund will buy companies at different points in the cycle), which mitigates the risk of deploying a concentrated amount
of capital at peak valuations.
The NWM Global Equity Fund is structured to provide diversification by investment style, market cap, geography, sector, and economic cycle while trading at compelling valuations. The various managers within the NWM Global Equity Fund have specific mandates that complement our North American equity mandates. Some of the mandates include: Greater Asia focused mandate; global small companies mandate; European manager with large cap-bias; Value manager that has a bias towards consumer staples; and a Nicola internal factor-based mandate that uses similar investment characteristics as our Canadian & U.S. equity managers but focuses solely on Europe Australasia and the Far East. We continue to believe global equities are an attractive place to invest
as Europe is earlier in the economic cycle than the U.S. and countries in Asia are posting double the GDP growth rates of North America with lower stock valuations.
As global money flows continue saturating fixed income markets, many investors have either reached out to longer debt maturities or down to lower credit qualities. By contrast, we have continued to generate fixed income returns, but not by taking interest rate exposure at historical low rates, and not by undermining credit investing discipline. Our fixed income strategies are defensive with low duration against potential interest rate volatility. In expensive credit markets with volatile tendencies—i.e. high yield bonds—we are defensive and stand ready to invest quickly when there are lower prices. We are shifting asset allocation to undervalued areas where we see attractive yield opportunities—i.e. niche private debt strategies.
With interest rates at historical lows, we have shunned longer maturities and the associated risk of interest rate volatility, just in case inflation comes out of hibernation. We certainly follow the argument that deflationary forces could continue keeping interest rates low for a long time. But until government bond yields normalize to become a larger component—versus credit spreads—of overall yields, our fixed income strategy will remain focused on credit investing. Our fixed income strategies are not reliant on interest rate prediction to generate steady income in their portfolios. The NWM Bond Fund, the NWM High Yield Bond Fund, the NWM Global Bond Fund, and the NWM Preferred Share Fund are all lower duration than their respective markets; the NWM Balanced Mortgage Fund and the NWM Primary Mortgage Fund are low duration by nature.
Not that there is much value in credit spreads either. In markets awash with liquidity, credit discipline has generally been overrun by undiscerning fund flows. Rather than join this blind chase for yield, we have not changed our credit standards. Instead, we have changed direction across many of our fixed income products, to non-traditional strategies that we believe offer sound risk-adjusted returns.
In investment grade, the NWM Bond Fund has been relying on credit spread trading strategies and Sun Life Private Fixed Income Plus Fund to add returns to flat lining investment-grade yields. With flattening yield curves, we can remain low duration to earn comparable yields at the short end, without the potential interest rate volatility.
The NWM Preferred Share Fund—focused on rate-reset preferred shares—is also earning high investment-grade credit spreads, 200-300 basis points above corporate bond spread of the same Canadian issuers. While we watch our exposure to preferred shares because of the market’s illiquidity and potential volatility, Canadian preferred shares offer significant yield premium for investment grade credit risk, particularly on a tax-adjusted basis.
The NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund remain core components in our fixed income stable. Despite competing capital in recent years, our underwriting criteria have been the same. Rather, we have accepted lower but still attractive yields for mortgages of the same credit quality. The secured and amortizing nature of mortgages, low loan-to-value ratios, and the high portion of multi-family properties in the NWM Balanced and Primary Mortgage funds make the funds standouts in risk-adjusted yield investments.
In non-investment grade credit, investment grade flows continue to rise into high yield bonds, leveraged loans and emerging markets for yield. While company fundamentals are generally positive, the central bank asset purchasing, the return of collateralized loan obligations (CLOs), and growing force of ETFs have created market environments based on sentiment rather than corporate credit risk analysis. In particular, we see a clear flaw and present danger in the portfolio construction of debt-weighted ETFs; the more debt a company borrows the more of it the ETF will own.
Past experience has witnessed high yield issuers and industry sectors taking advantage of abundant investor flows to over-lever, until they can’t—telecoms in 2000s, financials in 2008 and energy and commodities in 2015. And when a default wave arrives, these top-heavy ETFs will topple the most.
The NWM High Yield Bond Fund continues to be defensive, much of it in long/short, high quality, liquid and low duration positions. While the fund’s yield is lower than index, it has substantially less risk, and we stand ready to add credit exposure during episodes of volatility, as we did in 2008 and more recently in 2015.
In global bonds, credit fundamentals appear benign with positive signs of global economic growth. But again, we are wary of high prices and distortions created by abundant liquidity and low investing standards. While continuing to find relative value, much of the NWM Global Bond Fund is long/short and defensive. Keeping in mind that a flight to quality in credit markets is often a flight to U.S. dollar denominated debt repayment, the U.S. dollar exposures
in both the NWM Global Bond Fund and the NWM High Yield Bond Fund also serve as partial “risk-off” hedging.
While we play defense in the expensive markets, we have been moving on actionable private debt opportunities that offer attractive yields. Nicola Wealth Management has been investing in private debt for several years, and we recently launched the dedicated NWM Private Debt Fund.
To be sure, abundant capital flows have pervaded the private debt world as well, particularly in the leveraged buyout financing space. But the NWM Private Debt Fund’s focus is on under-banked niche opportunities where we can earn attractive yields while adhering to sound credit underwriting discipline. For these strategies—including receivables factoring, lower middle market corporate lending and special situations financing—we are often relying on best-in-class strategic partners that have unique access and expertise. Significantly, our pooled fund size is allowing us to do so cost-effectively by negotiating lower institutional fees for these funds and by averaging down these fees with no-fee co-investment participation.
Our diversified suite of fixed income products provides much flexibility to allocate and tailor our strategies across existing and evolving investment arenas; opportunistically deploying in some, patiently waiting in others. As such, our fixed income portfolio continues to deliver our traditional income returns in a challenging low-yield environment, but by non-traditional ways.
Canadian real estate remained relatively unscathed by the global financial crisis that hit many world markets including the U.S. However, we recognize that there are a number of internal pressures that currently apply to our Canadian market, most notably housing prices, which are above long term averages and are very expensive when compared to global peers.
Looking to the future, the largest determining factor driving real estate pricing will continue to be interest rates. Long term rates have been steadily falling since 1980’s, reaching historic lows in the intervening years following the 2008 financial crisis. Allowing for effects of inflation, real rates could be lower still. This low interest rate environment has led to a glut in borrowing rates, making mortgages attractive and compelling buyers into the market.
There are a number of questions that we need to consider that may impact real estate valuations moving forward:
- Were interest rates too high back in the 1980’s and 1990’s, and are current interest rates the new norm or should we anticipate a dramatic rise in rates as the global recovers?
- What will be the impact on asset prices with a longer term shrinking working age population?
- Will local and federal governments try to destroy the recovery in order to save it?
- Will governments try to increase interest rates to deflate asset prices?
The best we can do is to prepare and protect our portfolios against extreme eventualities that could manifest should interest rates rise. There are three key events that are top of mind for us and we feel we have positioned ourselves well to manage though each of these.
- Dramatic Rise in Interest Rates – when we acquire assets, we underwrite higher interest rates on mortgage re-financing to reflect the likely reality we will be faced with. Additionally, we continue to stagger loan maturities to prevent a sudden rise in the overall cost of debt for our portfolio. Ultimately, the only defense to rising interest rates is the ability to increase rental income to preserve and enhance cash flow. By targeting assets with a value creation proposition and by implementing an active approach to asset management, we believe we can be well positioned to continue to defend against rising rates.
- Freeze of credit markets – by maintaining a conservative loan-to-value ratio (LTV) at the portfolio level, including an adequate cash component, we can help off-set refinancing risks and also be in a position to acquire new assets without relying on debt (likely at distressed/attractive pricing). Part of this strategy can also include keeping a select number of unencumbered assets.
- Significant drop in asset prices – this event will likely be the result of a market-wide phenomenon/event, rather than a portfolio or property specific one, and thus everyone must be prepared to weather through this storm. We can achieve this by focusing on occupancy and rental cash flow. By maintaining a strong occupancy level, there should be good cash flow to service debt which will generate distributions, despite changes in the capital markets (i.e. valuations). By doing this, we can avoid being forced to divest in an unfavourable market.
If there are extreme risks, even with a low probability, is there a case to be made for liquidating everything and moving into a long cash position? We have examined this question as well and are of the view that our portfolios will withstand market tremors. Looking back across the past 10 years our portfolios have weathered shocks before including the recession following the 2008 financial crisis and the near meltdown of Euro zone 2010.
A good question to ask is how are we managing our three SPIRE Limited Partnerships so that we are creating a margin of safety given the potential for uncertainty as we look to the future? We have gradually lowered our LTV ratio and increased our cash margins. This has provided us with a margin of safety and enough available reserves to take advantage of any purchasing opportunities that may arise should there be a significant shift in market valuations.
In terms of actively managing our properties, we continue to target major markets which tend to be more resilient after a correction. Utilizing a diversification led model we employ strategies that include multiple asset classes – senior living, self-storage, multi-family residential, office, retail and industrial – stronger tenant covenants, staggering debt maturities and lease renewals, so that we don’t have a major spike in our portfolio in any one year.
We continue to add newer assets to our portfolio that are suitable for longer term holds and provide stable cash flows. Consideration is given to build-to-own with preleases in place, newer assets with lower future capex requirements, quality tenants with longer term leases, good long term hold locations, and lower average age of assets across the portfolio.
We are also closely watching the stability and reliability of our cash flow, working with tenants to develop good relationships to avoid turnover and providing stable cash flow. However, we continue to be discerning in selling assets where we have reservations about long term resiliency of asset class, market, and/or tenant risk.
Looking across all asset classes the current low interest rate environment has made more or less all investments expensive, including real estate. Historically low interest rates along with government’s policy of quantitative easing have contributed to an extended bull market in stocks and real estate. North America and much of rest of world has become expensive compared to long term average asset prices.
From our perspective as the leadership team of Nicola Crosby Real Estate Management, we see this as a time to hold off on adding more risk or move up the risk curve chasing yield. When looking at new assets our approach remains one of diligence and patience.
The current market reality is one of far more buyers than sellers, which presents a highly competitive landscape. Our methodology is to uncover opportunities that are not widely marketed using our deep rooted relationships. We are cautious not to stretch for assets that do not offer a long-term value proposition.
Additionally, we will continue to seek out value creation opportunities. In order to protect against potential changes to market conditions, our approach is to identify opportunities that include a value-creation component in addition to secure cash flow. We can achieve this by selecting opportunities with rental rate upside and with the ability to implement strategic capital plans as part of our active approach to asset management.
Lastly, we must acknowledge that risks may not be fully priced into any investment. Prior to removing conditions we have an extensive due diligence process.
Today, governments have less room and tools to maneuver to offset shocks than they did during previous emergencies – interest rates, government spending, and government debt – so extra caution is prudent management from our perspective.
If/when we have a major downturn, whatever the reason, we believe that we are reasonably well positioned to withstand the storm and recover well because of our proactive strategies and discipline.
In a normal economic environment, long duration fixed income has provided great diversification in a traditional investment portfolio by providing steady returns while also providing down side protection when markets sell off. However, with low or even negative real yields, the interest rate portion of fixed income no longer provides the same diversification benefits or compelling returns.
In fact, long duration assets may experience large capital losses in a rising rate environment. Additionally, high valuations for most traditional asset classes make it difficult to envision strong multiple expansion or spread compression on a go forward basis.
These factors combined lead to a higher probability of a lower return environment and the necessity to seek alternative solutions to traditional portfolio diversifiers and protect ones’ portfolio in case of a market downturn. Alternative strategies provide a strong diversification benefit to ones’ portfolio, able to provide positive returns in both risk off environments and prolonged bear markets where the market corrects significantly.
The uncorrelated returns of alternative strategies is achieved two-fold: investing in strategies that maintain low net exposure to underlying markets and by investing in arbitrage strategies which capture returns through inefficiencies in the marketplace.
By investing in strategies with low net exposure, we ensure that we do not have a long bias where investment returns are dictated by the overall direction of the market and thus are not impacted when markets go down.
The ability to invest both long and short allows more flexibility in the investment mandate allowing investors to profit from various market conditions. The combination of low interest rates and ETF passive flow has allowed some companies to thrive, whereas in a normalized environment these companies potentially would not even survive. As interest rates rise, the dispersion amongst investment returns from good companies and bad companies should increase allowing alternative strategies to benefit from their flexibility.
Arbitrage strategies benefit from increased volatility as their trading orientated nature allows them to capture higher returns from a larger opportunity set. Specifically, as rates rise, investors may further reduce duration risk which will create volatility in credit markets, presenting more opportunities for hedged credit strategies. With an increase in geopolitical and macroeconomic uncertainty, the closing of mergers may be questioned increasing spreads for merger arbitrage strategies. And volatility creating dislocations between fixed income markets and equity markets should benefit convertible arbitrage strategies. These arbitrage strategies all benefit from a pick-up in volatility whereas traditional investments generally suffer as volatility increases.
In the NWM Alternative Strategies Fund, the overall strategy consists of two main components: stable returns that are not influenced by the direction of other investments and tail risk protection. The Altegris Millennium Fund and Polar Multi-Strategy Fund are core holdings that represent managers who are market neutral and arbitrage focused respectively. Altegris Millennium Fund employs hundreds of teams of traders who invest both long and short in various markets based on company fundamentals while Polar Multi-Strategy Fund employs teams who uncover unusual mispricing in the marketplace due to specialized structures or complicated circumstances that the general public misunderstands. These two core managers position the fund to be absolute return focused, providing stable strong risk adjusted returns in most market environments.
However, large drawdowns in capital markets generally coincide to periods where correlation trends to one amongst all risk assets. To provide diversification benefits during this period, the fund also invests in divergent strategies, strategies that will provide strong return opportunities during bear markets. Thus, the NWM Alternative Strategies Fund also invests in trend following strategies. These strategies recognize ongoing trends in the markets and are able to profit even when all markets are going down.
In the NWM Precious Metals Fund, we invest in both physical bullion and stocks related to precious metals. We have a higher weight in stocks, particularly mid-sized firms who would not only benefit from an increase in gold and silver prices but also by increasing production.
As we move towards the end of the economic cycle, the uncertainty of what comes next drives which investments to own. Real interest rates are the key driver to gold returns. Gold historically has been an excellent at protecting purchasing power. Similar to alternative strategies, gold provides strong diversification in different environments in which most traditional investments are likely to suffer. Specifically during times of stagflation, if inflation is greater than interest rates, real interest rates are negative and your money is buying less every year. Inflation is eroding your purchasing power and interest
rates are not compensating you enough for this erosion. Gold protects your purchasing power when few other assets will.
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. 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 investment is generally intended for tax residents of Canada who are accredited investors. Some residency restrictions apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Crosby is a subsidiary of Nicola Wealth Management. All values sourced through Bloomberg.