- Are equities a better investment return?
- China’s goal to rebalance its economy adds to credit risk concerns.
- Japan: good news story or train wreck waiting to happen?
- Will the slowdown in the U.S. economy be recovered in 2014?
- American unemployment rate at its lowest level since 2008.
- Consumer sentiment: did U.S. shoppers see their shadows in the mall?
- What’s cramping the U.S. housing market’s style?
- Should Canada ride on the coat tails of the U.S. economy?
- Creating jobs in Canada is a matter of quality over quantity.
- Is a weaker dollar inspiring Canadians to deleverage?
- Canadian house prices continue to defy critics.
The NWM Portfolio
Strong returns across all asset classes suggest it was risk on in February.
Interest rates moved slightly higher with two-year Canada yields ending the month at 1.00% versus 0.95% at the start of the month. 10-year Canada’s backed up even more, ending the month at 2.43% versus 2.34%.
NWM Bond was up 0.3% in February as higher exposure to credit and low duration mitigated the negative impact from higher interest rates. Year to date, the Fund is up 1.1% – not bad given the environment and low duration of this fund.
Credit spreads also positively contributed to high yield bond returns, as NWM High Yield Bond increased 1.3%.
Global bonds were also higher, with NWM Global Bond increasing 1.5%. This is a good return given the Canadian dollar gained almost 0.6% against the U.S. dollar.
We would point out, however, NWM Global Bond has currency exposure to a number of currencies other than the U.S. dollar. We reference this exchange rate only to highlight the relative strength in the Canadian dollar during the month.
Mortgage returns were steady as always, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.5% respectively for February.
NWM Preferred Share returned 0.96% for the month of February, in-line with the overall markets as the S&P/TSX Canadian Preferred Share Index ETF returned 0.94% and outperformed the BMO Laddered Preferred ETF, which returned 0.67%.
Longer term we believe that longer duration preferred shares will be under pressure, and we continue to reduce our position in perpetuals. There were three new issues during the month, two of which garnered limited demand.
Manulife L was forced to re-price to $24.25 a week after announcing, and Algonquin Power suffered similar pricing pressure in the market and opened at $24.28. We avoided both issues in NWM Preferred Share, but will continue to look at the primary market for attractive issues.
Canadian equities were strong in January with the S&P/TSX gaining 3.9% (total return, including dividends), while NWM Strategic Income was up 2.8% and NWM Canadian Tactical High Income was up 2.7%.
Foreign equities were mainly stronger in February with NWM Global Equity up 3.4% versus 4.5% for the MSCI All World index, and 4.0% for the S&P 500 (all in Canadian dollars).
All our external managers were up in January led by Carnegie +6.1%, Edgepoint +3.8%, BMO Asia Growth & Income +3.1%, Templeton Smaller Companies +2.5%, and Cundill +1.2. NWM U.S. Tactical High Income returned 2.8% (+3.4% in U.S. $’s).
The REIT market continues to recover, with NWM Real Estate up 0.6% in February.
NWM Alternative Strategies returned 0.6% in February (this is an estimate and can’t be confirmed until later in the month), while gold continues to rebound from its collapse in 2013. Gold bullion was up another 5.6% in February and NWM Precious Metals increased 11.9%.
February in Review
Despite turmoil in Ukraine, markets rebounded in February with S&P 500 rallying 4.6% (4.0% in Canadian dollars) and the S&P/TSX rising a respectable 3.9%. Europe was also strong with the Stoxx Europe 600 up 5.0% in Euros and 6.8% in Canadian dollars.
Only Asia bourses were weaker, with Shanghai up 1.1% in local currency terms, but down 1.3% in Canadian dollars, while Japan was down 0.4% in yen and 0.8% in Canadian dollars.
The U.S. economy decelerated at the end of 2013 and early 2014, but markets appear to be looking past the recent softness.
Weather is suspected to have played a large part in the slowdown, and pent up demand from cabin-fever afflicted consumers could help economic growth in the coming months.
Also, with bond yields falling earlier in the month, investors increasingly view equities as their best hopes for positive investment returns.
The problem with U.S. stocks, however, is they are not the bargain they were a few years ago. The U.S. economy has had a few years of recovery under its belt giving investors time to position their portfolios accordingly.
Europe, on the other hand, is a different story. With signs that the Euro-zone economies may have finally seen their worst, investors are starting to pick through the ruins for bargains. With attractive valuations and the ECB standing ready to do its part if the economy falters, money is flowing into Europe.
So what’s up with Asia? A recent Goldman Sachs survey of 2,000 clients in Hong Kong and Tokyo found credit risk in China and the Emerging Markets to be their number one concern.
As highlighted last month, corporate debt in China has skyrocketed and many fear a “Lehman moment” could send China into a full-blown credit crisis.
The reality is, however, credit markets in China work very differently than they do in the U.S. Counter party risk is not as big an issue given the banking system is dominated by state-owned or controlled entities, as is the shadow banking system.
We could see the odd bankruptcy, like the recent default by Chaori Solar, China’s first corporate default in recent history, but a full-blown credit freeze is improbable. China would like to inject a little “moral hazard” into the market to let investors know they can lose money, but they will keep the pain threshold to a minimum.
What is a greater risk, however, is that China’s economy will continue to slow. Premier Li Keqiang recently left China’s targeted economic growth for 2014 unchanged at 7.5%, but remarked growth could slip to 7.2% before unemployment levels reached unmanageable levels.
China would like to rebalance its economy away from exports and capital investment and towards consumption, but it’s a process that will take years.
In the meantime, exports and manufacturing will still be responsible for carrying the bulk of the load. With the HSBC Purchasing Managers index falling to 48.3 in February (indicating the manufacturing sector is contracting) and exports declining 18%, many fear that China will need to do more to stimulate its economy.
The obvious answer as to how it will do this is by increasing infrastructure spending and capital investment, which will result in more credit. In other words, more of what China was hoping to balance its economy away from.
What is less of a concern is the recent decline in the Yuan. We do not view it as a sign capital is fleeing the middle kingdom. China runs a healthy current account surplus and has the largest currency reserve in the world. The Yuan doesn’t go anywhere the central government doesn’t want it to go.
China knows it must eventually move towards a market-based exchange rate. Letting the Yuan depreciate informs the market that the movement of the Yuan is a two-way street and can fall as well as increase. Welcome to our world, China! The capital markets are a perilous and unpredictable place.
Economic growth and trade is also an issue for Japan. Japanese fourth quarter GDP growth was revised lower to 0.7% versus initial estimates of 1%, and Japan posted a record trade deficit in January with imports up 25% versus the previous year.
A deteriorating current account balance is never a good thing, especially when you have the highest government debt-to-GDP ratio in the developed world.
Of course, much of these negative results should reverse as the year progresses with New Year holidays in Asia traditionally weakening Japan’s exports to the rest of Asia. Restarting a few nuclear reactors would also help as oil imports are killing Japan’s trade balance.
Longer term, what really matters for Japanese growth is the success of Prime Minister Abe’s so-called “third arrow,” namely, structural reform. Monetary and fiscal stimulus (arrows one and two) can help in the short term, but longer term, Japan needs productivity growth that can only be achieved with real structural reform.
Agriculture, labour markets, healthcare and female participation in the work force have all been identified as targets, but are also politically charged issues. What might work in Abe’s favour is a recent surge in Japanese nationalism, particularly as it pertains to China, and to a lesser degree, South Korea.
In order to prevent China from dominating the region, Japan is coming to the realization it will need to spend more on its armed forces. A strong economy is essential to having a strong military.
Recent disputes with both China and South Korea have soured Japanese public opinion towards both countries, while memories of Japanese occupation of large portions of Korea and China during World War II have stoked negative public opinion against Japan in these countries.
A recent poll, in fact, showed Prime Minister Abe’s favourability in South Korea has sunk below that of North Korea’s Kim Jong Un. For its part, China would love nothing more than to split the U.S.’s two major allies (South Korea and Japan) in Asia apart.
While all of this is unsettling, it could mean traditional political agendas in Japan would play a back seat to the desire to kick Japan’s economy out of the doldrums and enable structural reforms to work their magic.
Japan has the potential be the good news story of the global capital markets over the next few years, or the biggest train wreck in history.
Conditions are still favourable for the capital markets. The slowdown in the U.S. economy is likely temporary and we expect bond yields to continue moving slowly higher. No news is good news in Europe, and investor scrutiny appears to be shifting to Asia.
The U.S. Economy
Fourth quarter 2013 GDP was revised lower in February as personal consumption came in less than previously reported. 2014 is also likely to get off to a slow start with the polar vortex estimated to have taken a 0.3% bite out of GDP growth.
A recent Wall Street Journal survey of economists recently pegged U.S. GDP growth at only 2.2% in the first quarter, only slightly weaker than the fourth quarter’s 2.4% growth, but considerably slower than the average growth rate of 3.3% that the U.S. economy achieved in the second half of 2013.
Most of the slow down due to weather should be recovered later in the year as pent up demand drives growth higher. It is unlikely, however, that the slowdown is due entirely to weather.
To our pleasant surprise, the U.S. created a decent 175,000 jobs last month. December and January’s tally were also revised slightly higher such that the last three months have averaged job growth of 129,000, still disappointing given the U.S. averaged 194,000 new jobs a month last year.
The unemployment rate remained unchanged as more unemployed workers found jobs than dropped out of the workforce, the first time this has happened in nearly four years.
Add marginally attached workers and those involuntarily working part time, and the unemployment rate (referred to as U-6 unemployment rate) soars to 12.6%, still a big number, but lower than the 12.7% recorded the previous month, and at its lowest level since November 2008.
Also looking better was wage growth, which was up 2.2% year-over-year. The market feared the worst, but the job market was okay in February. Factor in the weather and it looks even stronger.
Inflation remains well below the Federal Reserve’s 2% target, but we may finally be seeing some upward pressure on the horizon.
As mentioned above, wage growth accelerated slightly in February. In addition, medical care has been trending higher after falling last year, and food costs could also be set to move upwards.
The U.N. recently reported global goods prices rose 2.6% in February, the largest increase since mid-2012. If the crisis in Ukraine continues to worsen, expect food prices to be volatile in 2014.
Low food prices have been one of the reasons inflation has been moving lower, though not all food has remained cheap.
Since 2008, bacon has increased 30%, more than triple the overall inflation rate. Of course, we would argue that the demand curve for bacon is inelastic, meaning that we will pay any price for this intoxicating delicacy.
Despite the apparent slowdown in the economy, the worst winter in recent memory, and an embarrassing performance by the U.S. Olympic men’s hockey team, American consumer sentiment has remained steady.
Seriously though, a confident consumer gives us conviction that the current weakness in the U.S. economy will be temporary.
Retail sales were weak in January, suffering their largest month-over-month drop in a year-and-a-half, and only the fourth back-to-back monthly decline since the recession. Year-over-year, retail sales suffered their smallest increase since late 2009. Sure, blame it on the weather.
Higher natural gas prices, which should translate into higher home heating costs, could also crimp future spending. Consumer spending actually increased in January, but this was driven by higher spending on health care as the new Affordable Care Act (ObamaCare) was rolled out, as well as higher utility spending due to the cold winter.
While consumers may have stayed away from the malls in January, this doesn’t mean they are saving more. The personal saving rate has remained low over the past several months and Americans are starting to borrow again.
Household debt in the fourth quarter increased 2.1%, the largest sequential quarterly increase since before the start of the recession. Versus year-ago levels, total debt posted its first increase since late 2008.
This is both a good and a bad sign. The fact that consumers are borrowing means they have confidence that they will have the ability to pay back their loans.
Likewise, lenders have the confidence to make credit available. More spending and consumption is good for the economy. The downside is that too much debt is what caused the financial crisis in the first place, and consumers have a poor track record of determining when they have too much debt.
Apparently the same goes for lenders. An area of particular concern is student loans. Presently comprising about 9% of total household debt, federal student aid has been one of the few consumer credit categories to experience consistent loan growth during the economic recovery. Unfortunately, it is also the only category where delinquencies have been increasing.
While it is true youth unemployment rates have remained high and it is harder for recent grads to find well-paying jobs, many also apply for student loans because they are easier to get than bank loans.
No credit checks are performed by the government and loans cover living expenses as well as books and tuition. For some, getting an education is secondary to getting money to live on.
Existing home sales in January declined for the fifth month in the last six, and housing starts were down 16% versus December levels. Again, blame it on the weather. I mean, who wants to build a house in the middle of a polar vortex?
Strangely, however, housing starts actually rose in the Northeast and fell in the South and Western parts of the U.S. Weather played a role, but it wasn’t the whole story.
Probably the biggest factor hurting the housing market are mortgage rates, which rose last summer as 5- and 10-year bond yields moved higher.
Bond yields have fallen again, however, with 10-year yields back well below three percent. Prices, while still attractive compared to levels reached at the peak of the housing boom, are no longer the bargain they once were.
There are also fewer homes available for sale, and investors who are able to make all cash offers have been aggressively snapping up what’s available.
Given the recovery in the economy and housing prices in general, it should come as no surprise that there are also fewer distressed sales and the shadow inventory, or foreclosed homes and mortgages delinquent for more than 90 days, has fallen rapidly.
No wonder sales are down. There’s nothing to buy. All this means that the U.S needs to build more homes, which is happening, and will be very positive for the U.S. economy.
The trade deficit came in largely as expected with machinery, aircraft and medical equipment exports being offset by higher petroleum imports. We would expect oil imports to moderate as the year progresses, and the trade deficit to gradually decline.
A decent employment report and firm consumer confidence makes us believe that the current weakness in the economy will be temporary. The housing market, while taking a breather, should continue to help drive growth higher.
The Canadian Economy
Despite an ice storm-induced GDP contraction in December, Canada finished off 2013 with a not-too-shabby 2.9% increase in Q4 GDP.
Poor weather and high inventories could pressure growth in the first quarter, but we would look to the U.S. as the key barometer for the future direction of the Canadian economy. U.S. leading indicators, in fact, have historically shown a fairly close correlation to Canadian GDP growth.
Wage growth moved slightly lower but still remains higher than in the U.S. Canada has consistently managed to create higher quality jobs than the U.S. since the recession.
Headline inflation grew at its fastest pace since June 2012, driven by a 2.1% increase in shelter costs. We would expect inflation to continue moving gradually higher throughout the year.
With winter storms forcing Canadian consumers indoors, we’ll give consumer spending a free pass in December, and probably January as well. Strong consumer confidence in February and pent up demand should translate into stronger sales as spring arrives.
Also helping is the recent weakness in the Canadian dollar, which makes cross-border shopping much less attractive. If sales continue to languish, we might be inclined to believe Canadians might be starting to finally deleverage.
House prices in Canada continued to defy the critics in February with the Terenet index up 5% versus last year. Existing home sales were down slightly in January, but again, the weather is likely partially responsible.
U.S. bond giants PIMCO recently joined the chorus of U.S. money managers predicting the imminent demise of the Canadian housing market, forecasting a 30% contraction over the next two to three years.
Perhaps, but unless interest rates or unemployment spikes, we don’t see the catalyst. Slower new home building is probably in the cards, and along with consumer deleveraging, could provide a headwind for the economy. We are not, however, so sure about a collapse.
A decline in the trade deficit is a good thing. The fact that it was due to lower imports is not.
Exports were driven by higher energy shipments to our southern neighbours while the decline in imports supports the view that there has been a buildup in inventories over the past few months that will need to be worked off in early 2014.
We are concerned about what the economic headwinds, a slowing housing market and deleveraging consumer could mean for the Canadian economy, but the decline in the dollar should help exporters and help compensate.
We still believe Canada should ride on the coat tails of a stronger U.S. economy.
Let us know your thoughts on December’s market activity 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.