Highlights This Month
- Worried investors bring markets down this month.
- Federal Reserve marks mid-2015 for tighter monetary cycle.
- How will a strong U.S. dollar impact interest rates?
- Equities expected to move higher as U.S. economy improves.
- Could the lagging Eurozone wreak havoc on U.S. stocks?
- Chinese government reforms result in economic slump.
- Decline in wage growth subdues consumer spending.
- How will the Feds respond to the possibility of deflation?
- U.S. housing market continues to disappoint.
- Positive gains for Canada’s job market.
- Will the Federal government try to cool Canada’s housing market?
- Is Canada’s economic growth sustainable long term?
The NWM Portfolio
Returns for NWM Core Portfolio were down 0.1% for the month of September. The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships. Actual client returns will vary depending on specific client situations and asset mixes.
Short-term interest rates moved higher in September with 2-year Canadas starting the month with yields of 1.10% and ending the month at 1.12%. 10-year Canadas backed up even more, starting the month with yield of 2.0% and ending the month at 2.15%. NWM Bond was down 0.2%.
High yield bonds were also lower in September with NWM High Yield Bond down 0.2%. Only the BMO Guardian High Yield was up during the month, gaining 0.8%.
Global bonds were up higher in September, with NWM Global Bond increasing 1.0%. The weaker Canadian dollar likely helped returns.
The mortgage pools continue to deliver steady returns, with the NWM Primary Mortgage and the NWM Balanced Mortgage returning 0.3% and 0.5% respectively for September.
NWM Preferred Share was down 0.46% for the month of September versus the BMO S&P/TSX Laddered Preferred Share Index ETF, which was down 0.78%. Higher bond yields were partly to blame for the sell-off in preferred shares as the 5-year Government of Canada was up 11 bps to 1.63%.
At the end of the month, S&P lowered its credit rating on Canadian bank Tier 1 issues and preferred shares, as they believe that regulators are more likely to enforce tougher bail-in actions.
The ability of regulators to convert preferred shares into equity is nothing new and even though BMO and CIBC preferred shares are now rated P-3H they are of higher credit quality than most P-2 preferred shares, particularly when compared to non-cumulative issues.
Canadian equities were weak in September with the S&P/TSX losing nearly 4.0% (total return, including dividends), while NWM Strategic Income was down 1.7% and NWM Canadian Tactical High Income was down 1.2%.
The cash position in the Strategic Income fund is currently about 3.0% and approximately 3% of our Canadian positions are covered and 2.0% of our U.S. holdings. We would expect these percentages to move higher as higher market volatility should lead to higher option premiums.
Recent trades include new positions in Brookfield Property Partners and engineering company WSP, while our Calloway REIT, Saputo, and Goldman Sachs positions were eliminated.
With the Tactical Canadian High Income fund, approximately 42% is invested in Canadian equities, of which 33% has call options written against them. Presently, 7% of the fund is in high yield bonds, 11% is held in NWM Balanced Mortgage, and 24% is in the PIMCO USD Monthly Income Fund. The pool also has put options written on a notional 57% of the fund.
Foreign equities were mixed in September with NWM Global Equity down 0.3% versus +0.1% for the MSCI All World Index and +1.7% for the S&P 500 (all in C$’s). Of our external managers, Carnegie and Edgepoint were up 1.6% and 1.1% respectively, while Templeton Smaller Company, BMO Asia Growth and Income, and Cundill fell 2.8%, 1.9%, and 0.6% respectively.
NWM U.S. Tactical High Income returned -1.6% in USD (approx. +1.3% in CAD) and is approximately 63% invested in U.S. equities, of which 47% has call options written against them. Presently, 12% of the fund is in cash, 25% is held in high yield bonds, and 26% in held in the PIMCO USD Monthly Income Fund. The pool also has put options written on a notional 57% of the fund.
The REIT market was flat in September, with NWM Real Estate up 0.1%.
NWM Alternative Strategies increased approximately 3.4% in September (this is an estimate and can’t be confirmed until later in the month). Altegris funds Winton, Brevan Howard, Millenium, and Hayman were up 1.9%, 4.4%, 4.8%, and 9.2% respectively. SW8 was down 3.7% while RP was down 0.2%.
NWM Precious Metals was down 15.2% with gold bullion down only 3.3% during the month.
September In Review
Canadian and U.S. equities were lower in September with the S&P/TSX down nearly 4% while the S&P 500 fell 1.4%. In Canadian dollar terms, the S&P 500 actually gained 1.7% as the loonie fell 3% during the month.
Outside of North America, the picture was mixed. Asia was strong, with Shanghai (China) and Japan up over 10% and 3% respectively, while Europe was basically flat, with the STOXX Europe 600 down just 0.4%.
Market action in early October is much less ambiguous. Every market is down.
A recent Barclay’s survey of 972 investors highlighted geopolitics as the greatest risk.
While the situation in the Ukraine appears to have stabilized for now, there are plenty of other things to worry about.
ISIS in the Middle East, Ebola in Africa, and stability concerns in North Korea ? with leader Kim Jong-Un absent from the public eye for more than a month ? are all weighing on the market.
In North Korea the fate of their “dear leader” is a relatively new concern that may or may not turn out to be significant. While the party line (in this case, the Communist party) is that Kim Jong-Un is recuperating from an undisclosed illness, there are rumors that he has been “replaced.”
Given the remarkable feats and athletic prowess of his father, Kim Jong-Il, who is said to have carded a 38 under round of golf the first time he picked up a club (including 11 holes in one!) and bowled a perfect game of 300, the disclosure that his 31 year old son is physically unable to be seen in public strikes us as, well, let’s just say inconsistent.
While we think all these geopolitical concerns have the potential to dramatically impact the markets, we suspect they are not the major cause behind the recent market weakness.
More likely, speculation around when the Federal Reserve will start to raise interest rates, and weaker economic growth in Europe and China, are top of mind for investors around the world.
Given the recent strength in the U.S. economy, and the labour market in particular, some forecasters have been predicting the first increase in interest rates could come even earlier.
According to Goldman Sachs, however, the last tightening periods of 1994, 1999, and 2004 saw the S&P 500 manage average positive returns of 7% during the six months before the first increase and 5% afterwards.
While the S&P 500 did record an average decline of 4% during the 3-month time period after the first increase, losses were temporary. It was only later in the tightening cycle when higher interest rates started to slow economic growth that the market suffered more meaningful corrections.
For this reason, when the Fed starts to raise interest rates is not nearly as important as how much and how quickly. If the Fed were to move to a more normalized interest rate policy, short-term rates could rise upwards of 3.5% to 4%.
We don’t think the Fed will increase interest rates anywhere near this amount. At least not for the foreseeable future.
The U.S. economy is not strong enough to endure rate increases of 3 or 4%. Rates will go higher, but even if the Federal Reserve increases interest rates 100 or 200 basis points, they would still be at levels historically considered simulative for the economy.
As a result, the U.S. dollar has been soaring, making U.S. exports more expensive. The U.S. is driving investors’ attention away from U.S. companies, with a higher percentage of their sales coming from abroad.
There is a limit the Federal Reserve will let the U.S. dollar strengthen, further reinforcing our view that interest rate increases will be measured.
This is why most strategists still prefer equities to bonds, despite the fact the market is statistically overdue for a correction.
It’s been three years since the S&P 500 has suffered a 10% decline. Valuations are elevated, but as long as the prospects for corporate earnings continue to improve as the U.S. economy slowly normalizes ? and interest rates remain low ? the environment for stocks is positive.
This doesn’t mean there won’t be more volatility, or even a few 10% corrections along the way.
It’s just that, barring another recession, we don’t see why stocks can’t follow the economy and corporate earnings increase.
We like companies’ exposure to the domestic U.S. economy. We also like Canadian companies with exposure to the U.S. economy.
The U.S. economy is recovering while the rest of the developed and developing world economies struggle and the shale oil and gas boom have given U.S. manufacturers a competitive advantage with lower energy prices.
But a lot of this has already been priced into the market.
Small cap stocks get nearly 80% of their sales domestically versus large cap stocks, which, according to Capital IQ, receive just under 60% of their sales from home.
Small cap stocks are currently correcting more than big cap stocks, but they also went up more during the recent bull market and are trading at higher valuations.
Despite the recent move in the U.S. dollar, it might be time to selectively look towards bigger cap stocks.
They tend to fair better when interest rates increase, and historically, as RBC Capital Market’s Jonathan Golub points out, S&P 500 valuations tend to move in tandem with the U.S. dollar as a stronger currency is a sign of economic strength.
Also, other economies like Europe have to recover sometime, right?
Eventually, yes. But Europe is sure taking it’s time.
Inflation, or more specifically the lack of inflation, continues to be a major concern in the Eurozone. Headline inflation hit a five year low of 0.3% in September while core inflation fell to a mere +0.7%.
Most market commentators have been pinning their hopes on the European Central Bank implementing some sort of quantitative easing program, but the details remain vague and implementation problematic given Germany’s reluctance.
Germany might become more receptive, however, as the German economy looks to have slowed dramatically in August.
After GDP contracted 0.6% in the second quarter, industrial production declined 4% in August as exports fell 5.8%, and factory orders plunged 5.7% ? the largest decline since January 2009.
Germany makes up about 30% of the economic output of the Eurozone so a contracting German economy would have severe repercussions for the whole region.
And don’t look to France or Italy for help. Neither is growing and high government debt levels continue to be an issue.
If this burden was to overwhelm the U.S. economy and growth in the U.S. was to also slow, well, then, you don’t want to own stocks.
We are not saying this will happen, but it is a legitimate concern for the markets.
Same goes for China. Industrial production has also slipped in the Middle Kingdom, with August’s lower-than-expected 6.9% increase at its slowest pace since 2009.
Weakness in the housing sector is a major concern. Real estate is estimated to comprise over 20% of the Chinese economy and housing sales are down nearly 11% year to date while construction starts have declined 10.5%.
Nationwide, prices fell 3.1% in the third quarter and the supply of unsold inventory is at record levels.
Part of the economic slowdown is the result of reforms the new Chinese government is trying to implement, such as an anti-government corruption crackdown, meant to instill more confidence in the average Chinese citizen’s government representatives.
Evidence of their efforts can be seen in the revenue declines of casino operators in Macau, with J.P. Morgan recently predicting gambling revenue will be down as much as 21% in September versus year ago levels.
Even more startling, the Scotch Whiskey Association recently reported consumption in China is down 46% in the first half of the year.
Gift giving is rampant amongst government workers and a decline in the sale of luxury goods in China is a sign the practice has been curtailed.
The recent “Umbrella Protests” in Hong Kong is also an indicator of the pressure Chinese rulers are under.
Reform is vital for the long-term health of the Chinese economy, but likely means slower growth in the short term.
The reason Chinese markets were stronger in September is investors believe China will ease off on reforms in the short term, in order to ensure GDP growth does not fall below 7%.
Already China has started to signal that the anti-corruption campaign that began last June is being wound down.
China has more options than Europe to ensure GDP growth doesn’t fall below acceptable levels, and investors are betting they won’t be shy to use them. Even better, valuations are cheap.
The threat of higher interest rates in the U.S. and slower growth in Europe and China are causing market volatility to increase.
We still think the recovery in the U.S. economy is positive for stocks, but concede that risks to valuations have increased.
The U.S. Economy
Second quarter GDP was again revised higher, to +4.6%, matching Q4 2011 as the strongest quarterly growth of the five-year economic recovery.
The ISM Manufacturing Index moved down marginally, but is still well into expansion territory. Durable goods orders were lower, but only against July’s spike due to higher aircraft orders.
Also, industrial production slipped slightly, likely due to auto retooling schedules.
Hopefully, the current strength in economic growth is a sign the U.S. economy is finally reaching take off velocity.
After a disappointing August, the U.S. job market got back on track in September, adding 248,000 new jobs last month and bringing the monthly average year to date to 227,000.
The unemployment rate also fell to 5.9%, its lowest level since July 2008.
Without wage growth, consumer spending will remain subdued and provide a headwind for future economic growth.
It will be hard for the Fed to raise interest rates if wage growth remains at or below the inflation rate.
Headline inflation fell in August for the first time since April 2013 as gasoline prices declined 4.1%.
Also declining were prices for apparel, used cars, and transportation services.
Inflationary expectations continue to decline with the breakeven yields of inflation-protected notes dropping to previous levels, triggering Federal Reserve action. Also, the surge in the dollar will put future downward pressure on the inflation rate.
September Conference Board consumer confidence pulled back from August’s strong reading due to concerns around the labour market.
Given the strong job report delivered at the end of the month and the general recovery in the labour market, we would expect consumer confidence to continue to move higher in future months.
Of course wage growth remains a concern with incomes still about 8% below 2007 levels.
Retail sales in August were decent and same store sales (for the few retailers that still report this number) in September were reasonably strong. This bodes well for third quarter GDP growth.
New home sales surged 18% in August, and while housing starts and permits declined, builder confidence was on the rise.
Existing home sales were lower in August after four months of increases. Purchases by investors comprised only 12% of total sales, the lowest since 2009.
In 2012, investors accounted for over one of every five sales, but higher prices and less distressed sales have served to moderate investor appetite for single family homes.
Overall, the housing market continues to disappoint. Slowing of demand from investors has exposed some structural weaknesses in the market.
High youth unemployment, elevated student loan levels, and a lack of wage growth has resulted in weak demand in the entry level home market, while credit has remained tight as banks are more conservative in their lending practices.
Overall, the positive trend for the U.S. economy continued last month.
The Canadian Economy
July GDP came in a little light, but year-over-year growth was still a respectable 2.5%.
August leading indicators were strong and September manufacturing indexes were both in expansion territory.
After losing 11,000 jobs in August, Canada’s job market came roaring back in September with 74,000 new jobs created. Because the participation rate was unchanged, the unemployment rate fell to 6.8%, its lowest level since December 2008.
The quality of the gains was high, with 123,600 private sector jobs created versus a loss of 55,600 self-employed jobs. 6,000 government jobs were also added.
Most of the new jobs were also full time, with only 4,800 part time jobs included in the 74,000 new job total.
The only negative thing we can say about September’s job report is the labour force survey has tended to be very volatile, and we can’t rule out the possibility that next month’s report will be disappointing.
Canada has averaged monthly gains of about 15,000 new jobs over the past six months. This is the number we would focus on.
There was a big jump in August Core CPI, from 1.5% to 2%. We would expect this increase to be temporary given the slack still present in the Canadian economy.
Having said this, the decline in the Canadian dollar will put upward pressure on inflation in the near term.
Wage inflation in Canada has been a little firmer than in the U.S., but we still don’t see any real sustained inflationary pressure coming from the labour market.
Retail sales slipped slightly in July, but this is not unexpected given the strong gains seen in June.
Vehicle sales were strong, up 2.5%, and housing related categories were up 4.5% year over year.
With increases in such big ticket purchases, it should come as no surprise that household debt levels are on the rise again.
After decreasing for three quarters in a row, household debt levels increased to 163.6% in the second quarter. They are, however, still below peak levels of 164.1% hit in Q3 2013, and up only 4.1% year over year, the slowest pace in 13 years.
The biggest reason consumer debt levels are on the rise is the housing market continues to move higher.
Existing home sales hit their highest level since 2010 in August and are 10% above their ten-year averages.
Calgary, Vancouver, and Toronto continue to be hot, with prices up 9.8%, 7.8%, and 5.0% respectively on an annual basis.
The Bank of Canada can’t be happy with what’s happening in the housing market.
If the Canadian dollar continues to move lower, the Bank of Canada might be inclined to raise interest rates, or at least intimate that they might raise interest rates, in order to get the housing market to cool.
Canada’s balance of trade moved into deficit position in August after three straight months of surpluses.
Auto and energy exports were the main culprits behind the decline in exports. While a strong housing sector will help Q3 GDP growth, a deteriorating balance of trade will hurt growth.
Lower oil prices and commodity prices in general are also a concern.
Offsetting this, a weaker Canadian dollar is positive for growth, as is the impact of a stronger U.S. economy.