Market Commentary: Is This Bull Getting Tired Of Running?


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were up 1.1% in the month of June and 6.0% for the first six months of the year.  The Nicola Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of Nicola Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

The Nicola Bond Fund returned 0.6% in June and is +4.0% year-to-date. It was a solid month for investment-grade credit as government bond yields fell and credit spreads tightened. Year to date low issuance coupled with strong retail demand for investment-grade bonds continues to provide technical support. With the dovish tone of the Fed, there is a supportive backdrop for investment-grade credit. During the month we increased allocation to the Sun Life Short-Term Private Fixed Income Fund and the PH&N Short Term Bond & Mortgage Fund.

The Nicola High Yield Bond Fund returned -0.8% in June, and is +2.9% year-to-date. Currency detracted from returns as approximately half the fund has USD exposure and the U.S. dollar depreciated by approximately 3.1% relative to the Canadian dollar. In base currency, the high yield market returns were driven by a broad risk rally as yields now are back at 12-month lows. The rally was supported by both government bond yields moving lower and spreads tightening with high-quality credit outperforming lower quality credit. BB-rated names outperformed B and CCC names for the month as spreads tightened more for quality names. Despite all in yields reverting to 12-month lows, spreads have not tightened as significantly. High Yield spreads sit at 448 bps approximately 60 basis points wider than last year. More recently, the Nicola High Yield Bond Fund increased its allocation to PH&N High Yield Bond Fund, Oaktree Global High Yield and Apollo Credit Strategies.

The Nicola Global Bond Fund was flat for the month. Balanced exposure to duration and spread sectors contributed to returns as spreads tightened in both developed and select emerging markets. Exposure to Argentina was particularly beneficial. However, returns were offset as currency detracted along with both agency and non-agency backed securities.

The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.3% and +0.4% respectively last month. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.0% for the Nicola Primary Mortgage Fund and 5.6% for the Nicola Balanced Mortgage Fund.  The Nicola Primary Mortgage Fund had 20.7% cash at month-end, while the Nicola Balanced Mortgage Fund had 9.6%.  Given the current high cash level in the Nicola Primary Mortgage Fund and the current lack of product available in the market, we are actively discussing strategic alternatives for this fund.

The Nicola Preferred Share Fund returned +0.5% for the month while the BMO Laddered Preferred Share Index ETF returned +0.3%.  5 year Government of Canada bond yields moved slightly higher ending the month at 1.39%. At the beginning of the month, the Office of the Superintendent of Financial Institutions (OSFI), which regulates Canadian banks, raised the regulatory requirements for banks to hold CET1 capital to over 10%. This is not a surprise as the regulator has increased this buffer by 25 bps after every semi-annual review since its introduction in June 2018.

All the major Canadian banks have ratios from 11% to 12%, however, the increases may put pressure for further preferred share issuance to create a buffer between their levels and the bare minimum. During the month Valener announced that shareholders had approved an acquisition by Noverco and would be redeeming their outstanding preferred share at par ($25). Artis Real Estate Investment Trust also announced that they would be redeeming their series G preferred shares. This aligns with their goal of shoring up their balance sheet by deleveraging.

After a volatile May, Equity markets were strong in June as the Fed completed a 180-degree shift in monetary policy with Powell now openly discussing the possibility of a rate cut. With rates moving down and the U.S. dollar weakening, the Materials sector and more specifically the gold sub-sector was very strong in June.

The S&P/TSX was up +2.5% while the Nicola Canadian Equity Income Fund was +1.7%. Industrials and Financials were the top positively contributing sectors. The top detracting sectors were Consumer Discretionary and Materials. We added Brookfield Infrastructure Partners this month. The company owns and operates critical infrastructure assets such as coal terminals, energy transmission and distribution, rail tracks, toll roads, and container ports. These assets are situated in 15 countries on five continents. Top contributors to the performance of the fund were Interfor, Heroux-Devtek Inc, and NFI Group. Largest detractors to performance were Spin Master, Pinnacle Renewable Energy, and Aritzia.

The Nicola Canadian Tactical High Income Fund returned +2.6% vs the S&P/TSX’s +2.5% return.  The Nicola Canadian Tactical High Income Fund’s relative outperformance was driven by the Nicola Canadian Tactical High Income Fund’s overweight exposure in materials and consumer discretionary names (West Fraser Timber & Magna International; those two names drove over 90bps of performance).

Option volatility dropped close to 10% during the month but the Nicola Canadian Tactical High Income Fund was still able to find opportunities where it was able to earn double-digit put option premiums with high single-digit downside protection on select names.  The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 64% and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market.  No new names were added to the Nicola Canadian Tactical High Income Fund this month.

The Nicola U.S. Equity Income Fund returned 7.2% during the month, while the S&P500 returned 7.0%.  Defensive sector positioning (overweight Utilities, Consumer Staples), and a 2.8% position in cash dragged on returns.  However, this was more than offset by the contribution from stock selection, as gains from Valero, Weyerhaeuser, and NVidia more than compensated for declines in Carnival and Alphabet.

The Nicola U.S. Tactical High Income Fund returned +6.1% vs +7.0% for S&P 500.  The Nicola U.S. Tactical High Income Fund’s relative underperformance was due to being underweight materials, energy & information technology.   YTD, the Nicola U.S. Tactical High Income Fund is up to a solid 15.1%.  Option volatility fell in June as markets and valuations rose, which made it difficult to write options on our previously held high-quality names (i.e. Costco, Home Depot).  As such, the Nicola U.S. Tactical High Income Fund has been very selective in deploying capital. The Nicola U.S. Tactical High Income Fund’s delta-adjusted equity decreased to 48.4%.  A new name added to the portfolio was Oshkosh Corp.  Oshkosh makes construction access equipment, military tactical vehicles, fire trucks, waste, and cement trucks. The portfolio remains defensively positioned with a lower valuation multiple, higher free-cash-flow, and lower leverage relative to the S&P 500.

The Nicola Global Equity Fund returned +2.4% vs +3.2% for the MSCI ACWI (all in CDN$).  The Nicola Global Equity Fund underperformed the benchmark due to country selection (underweight U.S. & Overweight Japan).  Sector contribution was mixed as the Nicola Global Equity Fund benefited from being overweight Industrials and Consumer Discretionary, but was underweight technology, healthcare, and materials.  Performance of our managers in descending order was Edgepoint Global +3.8%, Pier21 C Worldwide +3.2%, BMO Asian Growth & Income +2.4%, Nicola EAFE Quant +2.3%, Lazard +1.74%, and Pier 21 Global Value +0.3%.

The Nicola Global Real Estate Fund returned -1.1%% vs. the iShares (XRE) +0.1%. The softening interest rate narrative (“lower-for-longer”) is becoming the prevalent view and in fact, many market participants are now expecting potential rate cuts in the back half of the year. This has been a tailwind for the REIT complex. As interest rate level expectations have shifted down, REIT sector valuations are likely to find support. The USD/CAD exchange rate moved downward -3.1% which acted as a drag on the portfolio. U.S. dollar-denominated securities make up 34% of the portfolio. Overall we think that conditions are good for real estate and are focused on reasonably valued REITs with superior per-unit growth profiles.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of June 28th, May 31st performance for the Nicola Canadian Real Estate LP was +1.7%, Nicola U.S. Real Estate LP +1.4% (in US dollar terms), and Nicola Value Add LP +0.7%.

The Nicola Alternative Strategies Fund returned -1.3% in June (these are estimates and can’t be confirmed until later in the month).  Currency contributed -1.8% to returns as the Canadian dollar strengthened through the month. In local currency terms, Winton returned -0.6%, Millennium +0.5%, Verition International Multi-Strategy Fund Ltd +1.2%, Renaissance Institutional Diversified Global Equities Fund -1.9%, RPIA Debt Opportunities +1.2%, and Polar Multi-Strategy Fund +0.3% for the month. The Renaissance Institutional Diversified Global Equities Fund gave back some returns after having a very strong May.

The Nicola Precious Metals Fund returned +6.1% for the month while underlying gold stocks in the S&P/TSX Composite Index returned +16.3% and gold bullion was 4.6% higher in Canadian dollar terms. During the month we initiated a position in the RBC Global Precious Metals Fund and reduced our position in the Sentry Precious Metals Fund. The RBC team is one of the largest specialty global resource managers. They have a long track record with diverse experience in geology, engineering, finance, and investments. Ingrained in their process are a review of ESG factors (Environmental, Social, and Governance) with a focus on social license and governance structure. Currently, the fund is overweight mid-cap gold producers that are low cost while growing production with agile management.  Over the next quarter, we plan to completely exit the Sentry Precious Metals Fund in favor of the RBC Global Precious Metals Fund.

 

June in Review

Last month, the current U.S. economic expansion turned 10 years old, making it the longest on record.  At 120 months, and counting, the current expansion began in 2009 after the financial crisis, and has finally eclipsed the great expansion of the 1990’s.  As impressive as the current run has been, it pales in comparison to China’s 355-month streak.

Even Canada has notched a longer expansion, experiencing nearly 16 years of uninterrupted growth beginning in the early 1990’s.  Canada managed to avoid the dot com bust and 9/11 terrorist attacks that derailed the U.S. economy, but like the U.S., fell victim to the great recession.  Still, given the average U.S. expansion has lasted only 58 months, the current streak is noteworthy, so we take note.

Bull rally could catch a second wind

The current stock bull market, of course, had its 10th birthday earlier in the year, March 9th to be exact.  Given its duration, it’s natural to question whether the rally is beginning to tire.  Based on returns last month, we would have to conclude otherwise, and the rally could in fact be ready to catch its second wind.  On a price-only basis, the S&P 500 last month gained just under 7% (in U.S. dollar terms) while the S&P/TSX climbed just over 2%.  Year to date, the S&P 500 has rallied over 17% while the S&P/TSX has climbed over 14%.  This is the strongest first half performance for the S&P 500 in over 20 years, and best showing for the S&P/TSX in a decade.  Historically, both markets have had inconsistent results in the second half of the year after starting off so strong, though on average, results have been positive.

European stocks, corporate credit, and oil delivered impressive gains

U.S. and Canadian stocks are not the only risk asset to do well this year.  European stocks, corporate credit, and oil have also delivered impressive gains.  In fact, the only trade not working so far in 2019 has been being long U.S. dollars.  Under the surface, however, some cracks are beginning to show.  While the overall equity market was strong, it was defensive stocks that were doing most of the heavy lifting.  Real estate, health care, utilities, and consumer staples all outperformed the market.  Also stronger were larger companies and companies with stronger balance sheets.  This is not the market action one would expect of a market and economy performing strongly.

The biggest contradiction we saw in regards to market action in the first half of the year, however, was the steady march upwards in stocks in the face of consistently declining bond yields.   Lower interest rates are good for stock valuations so it’s not uncommon for the two to move in opposite directions, but the veracity of the decline in bond yields was noteworthy.  By month-end, the S&P 500 was trading about 6% above its 200-day moving average while 10 year U.S. government bond yields had plummeted 26% below its 200-day moving average.  Bonds appeared to be discounting something more sinister, like a recession and lower CEO confidence, and more economists forecasting a recession within the next 12 months appear to back this up.

We believe a slowdown in global growth, particularly manufacturing, is causing these concerns and the resulting decline in yields.  On the other hand, however, hopes central banks will come to the rescue with more stimulus is helping buoy equity returns and other risk assets.  We will look at both of these seemingly contradictory forces this month.

It is clearly evident the global economy has slowed.  Most countries have seen a material contraction in manufacturing purchasing manager indices, with some such as export heavyweight Germany, falling into contraction territory.  According to a McKinsey Global survey taken in June, nearly 60% of respondents believe current global economic conditions have weakened over the past six months.  While global growth has been under pressure for a number of months, what is particularly troubling for U.S. investors is the slowdown is now showing up in U.S. numbers as well.  Both hard and soft economic indicators have weakened, though employment and consumer spending has remained resilient.

 

The two most important factors impacting growth and business confidence are the brewing trade war between the U.S. and China and economic policy uncertainty revolving around what the Federal Reserve will do in regards to interest rates.  Again looking at the McKinsey Global survey, trade conflicts are cited by respondents as the top risk to global economic growth while the U.S. Economic Policy Uncertainty Index recently spiked up to levels last seen at the end of 2012.

 

A meeting between American President Donald Trump and China’s Xi Jinping at the G-20 Summit in Osaka Japan at the end of June has resulted in a re-start of talks between the two countries, however, there remains no clear consensus between the parties.  In a recent investor poll conducted by RBC Capital Markets, less than half the respondents believe a deal will be reached this year.  In the meantime, the volume of world trade is slowing and is now expected to grow at its slowest pace since the great recession.  While the U.S. and China dispute dominates the headlines, other countries are also using trade as a negotiating chip in global politics.  Under such an environment, business confidence, which impacts future business investment, has declined.

 

Along with lower inflation, the uncertainty around trade and declining global growth has central banks looking towards monetary easing once again.  In the Euro-zone, for example, ECB President Mario Draghi recently signaled the ECB could implement new monetary stimulus at its next policy meeting on July 25th, though he wasn’t specific on what that stimulus might look like given over-night interest rates are already negative 0.4% in the Euro-zone.  All this has put tremendous pressure on the U.S. Federal Reserve and its Chairman Jerome Powell. At one point last month, the market was discounting a 72% probability the Fed would cut rates 25 basis points at the Fed’s next meeting in late July, and 28% odds they cut 50 basis points.

By year-end, the market saw a 72% probability of at least 75 basis points of easing.  The odds came down a bit after a stronger than expected June employment report, but most still believe a July cuts is all but a done deal.  If by chance the Fed doesn’t cut in July, the market will be very disappointed and stocks will weaken and credit spreads widen.  As a result, financial conditions in the U.S. will tighten, which is just the scenario the Fed is trying to avoid presently and what is compelling it to consider cutting rates in the first place.

In other words, if they don’t cut rates in July, financial conditions will tighten and more or less ensure they have to tighten at the following meeting, or sooner.  Powell and the Fed are boxed in.  The question of whether the economy really needs lower interest rates given the unemployment rates is 3.7% and the real fed funds rate (Fed Funds minus inflation) is barely above zero, is irrelevant. The market wants it and the market usually gets what it wants. A perfect scenario for President Trump would be for the Fed to ease, and then reach a trade deal with China.  This could supercharge the market and the economy leading up to the Presidential election in 2020.

With just the threat of a recession, the resulting impact on interest rates should leave investors with no doubts over where rates are headed in the next recession. They are headed back down to zero, or lower.  Globally, 10-year government bond yields have been moving lower all year and continued to do so last month.  In the U.S. 10 year yield fell below 2% for the first time since 2016, while in hitting all-time lows in France (zero percent) and Germany (-0.3%).  According to Deutsche Bank Securities, as much as 20% of the $55 trillion global debt market presently yields less than zero. Newsletter writer Jim Grant recently pegged the amount of global debt yielding less than zero at just less than $13 trillion, glibly commenting that bond yields are at a 4,000 year low.

That rates have fallen as much as they have is unexpected.  At the start of the year, no one was forecasting rates would fall as low as this, even if they won’t admit it.  In a January Wall Street Journal survey of 69 economists, the average prediction for where 10-year yield would be by June was 2.96% with no forecast below 2.5%.  10-year yields closed the month around 2%.

Lower yields and the expectation the Fed will lower overnight rates has caused the U.S. dollar to decline against most major currencies.  The Canadian dollar, in fact, appreciated over 3% against the U.S dollar in June and is +4.0 % so far in 2019.  According to RBC Capital Markets June investor survey, 36% expect the greenback to continue to slide, as opposed to 25% who expect to see the dollar strengthen in 2019.

While we would argue U.S. dollar weakness was the major factor behind the move in most foreign currencies last month, the strength in the Canadian dollar can also be attributed to some uniquely Canadian issues.  Despite concerns earlier in the year that the Canadian economy could fall into recession, growth has surprised to the upside with March and April seeing the fastest two months of economic growth since the end of 2017.  A weak oil sector, global trade tensions, and a slumping housing market had the Bank of Canada on high alert, but home sales rose in May to their highest level since January 2018 and job growth remains strong with the unemployment rate hitting an all-time low in May.  Unlike many developed countries, Canada’s inflation rate has also turned higher.

Based on the recent strength of the Canadian economy, most economists don’t think the Bank of Canada will follow the Federal Reserve in lowering rates this year, though they are not as optimistic for next year, especially given high Canadian consumer debt and concern over the trade war.

As a base case, Bank of Canada senior deputy governor Carolyn Wilkins sees trade conflicts and uncertainty hurting Canadian GDP by as much as 2% over the next two and a half years and up to 6% and under a worst-case scenario.  The result is a bit of a balancing act for Bank of Canada Governor Stephen Poloz.  The current strength of economy and fears of re-stoking the housing bubble is acting as a deterrent against Canada matching any potential rate cuts south of the border.  On the other hand, the resulting stronger Canadian dollar is a most unwelcome development for future economic growth.  The spread between the Canadian and U.S. two year government bond yields has narrowed from over 80 basis points in March to just over 20 basis points in July, making Canada and its currency a much more attractive destination for foreign capital flows.

Bitcoin and gold taking advantage of U.S. weakness

Also taking advantage of the weakness in U.S. dollars was gold and cryptocurrency mainstay, Bitcoin.  The major knock against holding gold is it doesn’t pay a distribution or interest rate.  In today’s low or negative-yielding world, however, this disadvantage is greatly diminished as investors become more concerned with the preservation of capital than the return of capital.  Some investors, however, view Gold as a “dinosaur” and are drawn to the allure of blockchain technology and cryptocurrencies like bitcoin.  After reaching a high nearly $19,000 per token at the end of 2017, bitcoin fell over 80% in 2018 to just over $3,000 per token.  By the end of June, bitcoin had recovered to just over $12,000 per token.  We’re too old to understand bitcoin so we’ll stick with gold.

Growth rates are expected to moderate in 2020 and 2021

Prospects for the dollar, gold, stocks, and bond yields will be heavily dependent on what the Federal Reserve does, not only in July but for the rest of 2019.  Inflation is low but relatively stable.  Growth rates are expected to moderate in 2020 and 2021, but they are still positive and haven’t changed much over the past year and a half or so.  President Trump has been very vocal about how well the economy is doing, but then he berates the Fed for not cutting rates.

The stock market rallies when the economy looks to be faltering because it boosts the case for the Fed to be cutting rates.  This is why defensive stocks have been outperforming.  Lower interest rates are driving stocks higher, not earning or causing economic growth.  This leaves the rally vulnerable if the Fed disappoints and decides current economic conditions don’t warrant a cut in rates.

The Fed will cut in July, maybe not 50 basis points, but at least a quarter of a point (25 bps).  The market will be happy, but the underlying reason behind the Fed’s probable actions should give investors pause.  If the economy continues to slow, it’s unlikely the Fed has the firepower to turn the economy around.  The Fed’s not ready to fight a recession right now.  A mild recession, maybe, but a more severe downturn?  They are short on ammunition with rates already so low.  There is always the option of more quantitative easing and money printing, but the efficacy of these unconventional monetary policies are under scrutiny.   Negative interest rates don’t seem to be helping the ECB or Bank of Japan manage growth and inflation in Europe and Japan.  Fiscal policy will likely be needed to fight the next recession.  More on that next month.

 

 

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. Returns are quoted net of fund/LP expenses but before Nicola Wealth portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. For a complete listing of Nicola Wealth Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg. Effective January 1, 2019 all funds branded NWM were changed to the fund family name Nicola. Effective January 1, 2019 Nicola Global Real Estate Fund, Nicola Canadian Real Estate LP, Nicola U.S. Real Estate LP, and Nicola Value Add LP adopted new mandates and changed names from NWM Real Estate Fund, SPIRE Real Estate LP, SPIRE US LP, SPIRE Value Add LP.