Highlights This Month
- GOOD NEWS FOR GLOBAL EQUITY MARKETS.
- WHY INVESTORS FLOCK TO BONDS DESPITE LOW RATES.
- CONCERNS ABOUT THE EURO-ZONE’S DEFLATIONARY SPIRAL?
- CAPITAL MARKETS DRIVEN HIGH BY CENTRAL BANK MONETARY POLICIES.
- BOVINE FLU, DROUGHT AND UKRAINE CRISIS IMPACT INFLATION.
- HAS THE U.S. ECONOMY FINALLY RECOVERED?
- NO RISK OF INTEREST RATE INCREASES ANYTIME SOON.
- WHY IS THE CANADIAN JOB MARKET TRAILING THE U.S.?
- A FIRST FOR HEADLINE INFLATION SINCE APRIL 2012.
- NO FRENZY IN CONSUMER SPENDING THIS SPRING.
- HOW LONG WILL HOUSING BE AN ECONOMIC STRENGTH IN CANADA?
- THE CANADIAN ECONOMY NEEDS A BOOST FROM THE U.S.
The NWM Portfolio
Returns for the NWM Core Portfolio were up 0.1% for the month of May. The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.
Returns were positive in most asset classes in May, as both bonds and equities delivered positive returns.
Interest rates continued to move lower last month with two year Canada yields ending the month at 1.05% versus 1.06% at the start of the month. 10-year Canada’s rallied even more, ending the month at 2.25% versus 2.40%.
NWM Bond was up 0.5% in May with all our managers contributing positive results during the month.
High yield bonds also delivered positive results during the month, with NWM High Yield Bond increasing 0.2%. BMO U.S. High Yield (Montegy) led the way with a 0.7% return, followed by PH&N at 0.6% and Picton Mahoney at 0.4%. BMO Guardian High Yield was down 0.4% in May.
Global bonds were stronger, with NWM Global Bond up 0.5% as emerging market debt and currencies performed well in May.
The mortgage pools continue to deliver steady returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.5% respectively for May.
NWM Preferred Share returned -0.62% for the month of May, outperforming the BMO S&P/TSX Laddered Preferred Share Index ETF at -1.12%. In early May, much needed supply came to the market with seven new issues totaling over $2.5 billion.
The preferred share market sold off as it digested this glut of new issuance, helping to bring the market back to more normal conditions. Previously, prices had been driving higher due to a squeeze on supply from more than $5 billion in announced redemptions.
The fund participated in most of the deals for their attractive coupon or scarcity; the new TD preferred share marks the first time in 5 years that they have come to market.
Canadian equities were weak in May with the S&P/TSX losing 0.2% (total return, including dividends), while NWM Strategic Income was up 0.3% and the NWM Tactical High Income (CDN) was up 0.8%.
With the Canadian Tactical fund, we wrote put options on 15 existing positions and have written put options on a notional 64% of the fund.
Foreign equities were strong in May with NWM Global Equity up 0.9% versus 1.1% for the MSCI All World Index and 1.4% for the S&P 500 (all in CAD).
NWM Tactical High Income (USD) returned +0.8% (+1.9% in USD) with 27 put positions written on existing positions.
The U.S. Tactical fund has approximately 42% invested in long-only U.S. equities, 30% in high yield bonds, and recently established a new 24% holding in the PIMCO USD Monthly Income Fund.
The Fund has also written put options on a notional 55% of the fund.
The REIT market was stronger again in May, with NWM Real Estate up 0.5%.
NWM Alternative Strategies returned -0.2% in May (this is an estimate and can’t be confirmed until later in the month) and gold declined 4.3%. NWM Precious Metals was down 7.0%.
May In Review
Global equity markets continued to push higher in May with most ending the month in positive territory, despite the headwind of a stronger Canadian dollar that gained over 1% versus the U.S. greenback.
In fact, Canadian equities were one of the few laggards, with the S&P/TSX down 0.3% in May compared to a 1.4% rise in the S&P 500 of 1.4%.
Year to date, however, Canadian equities are still outperforming as most U.S. equity indices have struggled to maintain momentum of any kind, either positive or negative.
Volatility, as measured by the VIX, has been below its long run average for 74 straight weeks, a feat not seen since 2006 and 2007.
The market itself has not suffered a 10% correction in almost 500 days and has been largely range bound, with an annualized peak to trough loss of only 5% versus a 15% historical average.
In fairness, one could say much the same in regards to the economy, with very little dispersion occurring between the various forecasters.
One index that has bucked the trend and has performed more erratically has been the small cap Russell 2000.
The recent performance of the Russell 2000, which was down 0.1% in May and is basically flat year-to-date versus a 7.2% gain for the S&P 500, has some drawing comparisons to 1994, when the broader market was also range bound and small cap stocks lagged.
It was also the year the NY Rangers won the Stanley Cup for the first time in 54 years, and need I remind you, they are in the finals again this year.
Of course, the team they played in the 1994 finals was our very own Vancouver Canucks, so we know 2014 won’t be unfolding exactly like 1994.
We would be concerned if the small cap underperformance was the result of a decline in market breadth.
When market leadership narrows such that an ever decreasing number of big cap stocks are the only thing keeping the market from falling, a correction is usually just a matter of time.
In this market, however, most sectors continue to perform well, with transportation, financial and utility stocks not confirming the weakness seen in small caps.
Also in 1994, while the S&P 500 struggled and ended the year down 1.5%, it was up 20% to 34% over the next five years. Go Rangers go!
While small cap weakness is not worrying traders, the continued downward movement in bond yields are.
Government bonds are considered risk-free investments. It’s odd to see risk-free and risk assets (stocks and high yield bonds) both rallying at the same time.
We get why a stronger economy is good for risky assets, but one would expect an improving economy to stimulate the demand for money and result in interest rates moving higher, not lower.
Is the bond market telling us the economy is weaker than the stock market thinks? We don’t think so.
The downward move in yields is likely a result of a shortage of product given central bank buying and smaller government budget deficits.
In addition, pension fund rebalancing after large equity gains last year is likely causing demand for bonds to increase. Pension funds tend to have long duration liabilities so holding longer term assets helps them manage risk.
Also, don’t forget it’s a global world. Falling rates in Europe make U.S. interest rates look more attractive by comparison, even given how much they have already fallen.
While 10-year U.S. government bonds yield 2.6%, German Bunds pay a mere 1.3% and Japanese 10-year bonds return a mere 0.6%. Even more astonishingly, Spanish 10-year bonds now yield the same as U.S. Treasuries.
Given the future prospects for their respective economies, where would you park your money if you wanted to protect capital?
It’s not just U.S. Treasuries that have been in demand. Investors have been moving up the risk curve and also bidding up the price of risker U.S. debt and higher dividend paying equities.
Perhaps the best example of complacency and lack of risk aversion can be seen in investors’ attraction to emerging market securities.
Shunned a few months ago, the MSCI Emerging Markets Stock Index has recovered back to levels last seen in October and year-to-date is outperforming the MSCI Global Index.
Same in the bond market, with emerging market debt up 6% so far this year versus less than half this amount for U.S. Treasuries.
The riskier the better, apparently, with the so called “fragile five” (Indonesia, Brazil, South Africa, Turkey, and Nigeria) providing some of the highest returns.
In fact “frontier” markets, which are even smaller and less liquid than emerging markets, are handily beating emerging and developed market equities, and have generally been less volatile than either over the past 10 years.
Well, Europe might be more volatile than the emerging markets, but as mentioned above, money is still flowing into their capital markets.
In a world awash in liquidity and searching for yield, beaten down stocks and high government bond yields makes the Euro-zone a prime target, particularly securities issued by peripheral Euro-zone governments.
First quarter GDP increased a mere 0.2%, but the manufacturing sector is starting to show some life with the purchasing manager indices of most countries in the Euro-zone above the magic 50 level.
What worries the Euro-zone, however, is inflation – or more precisely, the lack of inflation.
The Euro has been saved (for now), but the medicine doled out to countries such as Italy and Spain has resulted in high unemployment and slow or no economic growth.
Wages and costs need to come down in order for these countries to become more competitive in the global marketplace.
Unfortunately, the resulting decline in prices risks driving the Euro-zone into a deflationary spiral.
It’s one thing for Greece to have deflation, but when inflation in Germany starts to plummet, like it did in May when it reached 0.6%, the ECB is compelled to take action.
Most Euro-zone countries still carry too much debt, and deflation makes it virtually impossible to work down. In addition, deflation can also lead to an appreciating currency, which provides a further headwind to growth and leads to even more deflation.
On June 5th, the ECB followed through with their promise to fight deflation by announcing a series of new monetary policy initiatives.
The ECB suspended the weekly sterilization of bank funds (which means they were offsetting any transactions that would normally increase money supply with other transactions that decrease money supply) and announced €400 billion in long-term loans to banks.
More significantly, however, the ECB lowered the interest rate it pays to banks on overnight money to minus 0.1%.
This means if a bank wants to leave deposits with the ECB, they not only earn no interest, they actually have to pay the ECB for the privilege. The goal is to encourage banks to increase their lending activities which will hopefully lead to an increase in economic activity.
The ECB also alluded to the potential for quantitative easing like asset purchases in the future, but this will be tough to implement given the Bundesbank’s aversion to money printing.
No such qualms towards quantitative easing in Japan, with Nikko Asset Management’s Takumi Shibata expecting total assets at the Bank of Japan to reach a size equal to approximately 60% of Japan’s annual GDP by the end of the year.
By comparison, the U.S. Federal Reserve’s balance sheet is expected to reach a level equivalent to only 25% of GDP.
The Bank of Japan’s goal is to help the country extract itself from the grips of deflation and finally start delivering meaningful economic growth after decades of stagnation.
So far so good. First quarter GDP grew almost 6%, though much of this was due to consumer buying before the consumption tax was increased from 5% to 8% on April 1st.
Japan has a lot going for it. The World Economic Forum recently ranked Japan as the ninth most competitive economy out of 148 countries.
The Bank of Japan is doing everything they can to increase this ranking even more by weakening the Yen.
It might not be enough, however. Japan has accumulated a world class government debt problem and a loss in confidence by domestic and global investors could result in plummeting bond prices (higher interest rates).
Structural reforms are key. Japan cannot rely on the short term impact of fiscal and monetary stimulus, and needs to show it can deliver consistent and sustainable economic growth.
But how high can valuations get? The next test will be when the U.S. Federal Reserve signals higher interest rates are on the way.
The U.S. Economy
First quarter GDP was revised from +0.1% to -1.0%, with a larger draw down in inventories accounting for much of the negative adjustment.
While this is negative for first quarter GDP growth, it could bode well for growth in the second quarter as companies will have lower inventories to work off before needing to re-order.
Leading indicators remain positive and manufacturing indices continue to point to continued future growth.
With May’s increase in non-farm payrolls of 217,000, for the first time since the late 1990’s the U.S. has created more than 200,000 jobs four months in a row.
Total U.S. payrolls also exceeded its pre-recession peak of January 2008, meaning the U.S. has finally recovered all the jobs lost during the recession.
Of course, the U.S. working age population has also increased by 15 million during this time frame so the unemployment rate, which was unchanged in May at 6.3%, is considerably lower than the pre-recession low of 5%.
Also lagging in the job market is wage growth. At around 2%, wage growth is barely keeping pace with inflation as many of the jobs created during the recovery have been in lower paying industries.
While the U.S. lost about 1.6 million higher paying manufacturing jobs, it has added about 940,000 jobs in the accommodation and food service sectors.
We also suspect that the increase in the number of jobs is inflated given the impact of the Affordable Care Act on employer hiring practices. If an employee works more than 30 hours a week, their employer is obligated to provide them with healthcare insurance.
Because of this, some workers have seen their hours reduced to less than 30 hours per week, thus essentially creating two jobs where only one existed previously.
In other words, we might have more jobs, but not necessarily more workers in the workforce with individuals working two or potentially even three jobs.
Drought in California, crisis in the Ukraine, and bovine flu have all contributed to the increase in food inflation. Also on the rise are medical expenses and housing costs.
A mixed month for consumer confidence, but not significant enough to make us concerned regarding future consumer spending.
April retail sales were up a lackluster 0.1% but improved in May as warmer weather and promotions got consumers off the couch and into the shops.
Auto sales were particularly strong in May, up 11% to an annualized 16.77 million.
The rebound in the housing market and strong stock market has resulted in household net worth hitting a record $81.8 trillion in the first quarter.
While this is good news and positive for future consumer spending, what is concerning is that consumer debt is also increasing.
This is good for the economy in the short term. But with many consumers still needing to deleverage and one of the causes of the financial crisis in the first place, we are concerned lessons learned during the great recession may be fading more quickly than we would have thought.
New and existing home sales increased but are still down on a year-over-year basis.
Affordability remains the big concern as prices continue to move higher and mortgages have become harder to get.
At 5.3 months of sales, or 2.3 million existing homes, the inventory of homes available for sale remains below that of a balanced market.
Corelogic’s Mark Fleming believes the true inventory might be even less. Many of the homes currently for sale could be considered obsolete with the average days on the market for homes sold considerably lower than the average days on the market for homes that are still for sale.
This bodes well for the new home construction, as there is likely a demand for new product.
The key, however, is first time buyers. Household formation remains below normal with many 18 to 34 year olds living with their parents.
According to Deutsche Bank, if the average number of people per household were to return to levels seen in the early 2000’s, demand for new homes could increase by more than 4 million.
The problem, however, is in order to move out and buy a home, these young Americans need well-paying jobs, and these are in short supply.
As mentioned above, most of the jobs created during the economic recovery have been low paying service and retail positions.
As a result, homeownership rates for 25 to 34 year-olds are just under 42% presently versus 49% 10 years ago.
Same with mortgages. Banks are tightening credit standards making it harder for new home buyers to secure a loan. In 2003, almost a third of 27 to 30 year-olds had mortgages compared to only 21% today.
It’s either glass half full or half empty. Either the youth represent a significant source of pent up demand which will eventually lead to future growth, or their lack of buying power is symbolic of a more systemic problem of an economy that will continue to grow below its potential.
We believe it’s the former, but we are keeping our eye on the latter.
Americans are spending, but the rest of the world is not. At least that’s the message we take from the April international trade report, with imports up a strong 1.2% while exports contracted 0.2%.
Given exports have now contracted four of the past five months and the trade deficit has reached its highest level in two years, international trade is shaping up to be a significant headwind for economic growth in the second quarter.
At the very least, the U.S. economy appears to be the strongest in the developed world.
The contraction in Q1 GDP is a concern but is likely at least partially due to severe winter weather.
Don’t get us wrong: while the economy might be gaining some steam, it’s far from a normal recovery.
The Canadian Economy
Housing and business investment both contracted while international trade added to growth only because demand for imports fell more than exports.
Energy was the lone stand out with oil and gas extraction up 2.4%. Much of this was due to the cold U.S. winter and the increased demand for energy.
Don’t bank on this again next year. Leading indicators remain positive, but the Ivy Purchasing Manager’s Index dipped below 50 in May, indicating the manufacturing sector is contracting in Canada.
Overall, there is nothing in this month’s numbers that would make the Bank of Canada think they need to be raising interest rates any time soon.
Canada added almost 26,000 new jobs in May, but full-time positions actually declined by just over 29,000 jobs. Only a 54,900 increase in part-time positions enabled Canada to report a good headline number and match consensus estimates.
In fact this has been the story for the past year. Full-time employment is down 26,700 positions, or 0.2% over the past 12 months, while part-time jobs are up 112,200 positions, or 3.4%.
Approximately half the increase in part-time workers is due to workers choosing part-time work for personal reasons while the other half were forced into part-time work due to economic conditions.
It is estimated there are more than 1 million Canadians who would prefer full-time jobs but are stuck working part-time jobs.
This number has increased by 54,000 over the past year, or 5%. Unlike the U.S., we can’t blame the Affordable Care Act for the increase in part-time workers.
With two-thirds of the new jobs in May coming from the low paying accommodation and food service sectors, it’s no wonder wage gains have been hard to come by.
Over the past six months, Canada has added an average 3,000 jobs per month, all from the government sector and part-time. Most of the gains have also come from one Province, Alberta.
At one time, Canada’s job market was materially outperforming our neighbors south of the border. Now, it’s the other way around.
Wage growth was the last hold-out, but now even this is trailing the U.S.
Natural gas, in fact, was up 26%. All 12 subcomponents were up in May — also a first since April 2012, with increased shelter prices a big contributor in the month.
That’s a big jump from last month; let’s see if it’s sustainable.
Retail sales in March declined for the first time in 2014. Auto and clothing were the two weak links in March.
Excluding these two sectors, retail sales would have increased 0.2%.
The housing market has cooled from its red hot pace a few years ago, but sales and prices remain firm.
Lower mortgage rates have helped fuel demand, but higher prices have likely eliminated any increase in affordability.
We remain concerned that Canada is overbuilding and a possible oversupply maybe be developing.
National Bank’s Marc Pinonneault recently pointed out, however, that developers may be scaling back as the housing starts over the past 12 months have lagged the number of building permits that developers have taken out.
This would be a good thing. Housing starts have indeed been volatile over the past few months, but May’s number was larger than most had expected, and well above population growth. To be continued.
Canada’s balance of trade moved back into a deficit position in April as energy exports declined after increasing almost 30% during the past winter.
Overall, not much to like this month in regards to the Canadian economy. Housing remains the key area of strength, but for how much longer?
We need the U.S. economy to start pulling us along.
Let us know your thoughts on May’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.