Highlights This Month
- Poor performance of the Euro is a potential future threat to the global economy.
- Demand for oil has been firm, but the real problem is supply
- The U.S. economy has gained momentum and separated itself from the pack.
- There are multiple risks that could bring the current business cycle to an abrupt end.
Nicola Wealth Management Portfolio
Returns for the NWM Core Portfolio Fund were up 1.1 in the month of June. The NWM Core Portfolio Fund 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.
Both Canadian and U.S. yield curves continued to flatten last month, but for different reasons. In Canada, it was falling 10 year yields that caused the slope of the yield curve to decline, while higher two year yields impacted the U.S. yield curve. The NWM Bond Fund generally benefited from lower Canadian yields and was up 0.3% last month.
NWM High Yield Bond Fund gained 1.0% in June and is +2.9% year-to-date. At mid-year, high yield credit spreads remain tight by historical standards, reflecting strong U.S. economic conditions (fundamentals) and little new issue bond supply in the market (technicals). This contrasts with U.S. Investment Grade and Emerging Markets credit spreads which widened in June, continuing the year-to-date weakness of those credit markets. The Fund remains cautious at these tight high yield spread levels, preferring to earn returns opportunistically and with some long/short positioning. Apollo Credit Strategies was a notable uncorrelated out performer in June, with significant gains from both its largest long and short positions.
The NWM Global Bond Fund was up slightly, returning 0.2% as the US dollar strength buoyed fund returns. Emerging Markets continued to weaken as the trend of credit spread widening remained. Ukraine, Argentina, and Indonesia led the broad-based sell off decline in EM markets, hurting the Templeton Global Bond Fund. We remain constructive on the long term fundamentals of EM; however, our positions in Manulife Strategic Income and Pimco Monthly Income Fund help diversify away from the short term volatility of our EM exposure. This strategy largely played out during the month as a higher weight in US assets, particularly high yield, helped support returns amongst EM weakness.
The Mortgage Pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM 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 4.45% for the NWM Primary Mortgage Fund and 5.4% for the NWM Balanced Mortgage Fund.
The NWM Preferred Share Fund returned 0.1% for the month while the BMO Laddered Preferred Share Index ETF was unchanged. The preferred share market was quiet for the month trading on low summer volumes within a muted +/- 0.3% range while five year Bank of Canada yields traded lower from 2.11% to 2.07%. The National Bank issue (4.95% with a 277 basis point reset spread) started trading on June 11th and mirrored the market ending the month at exactly $25. Both TD and BMO announced redemption of non-NVCC issues, more than likely paving the way for the banks to issue new preferred shares in the future. Enbridge preferred shares received a bid as the L3R line was approved along ENB’s preferred route and the company put out a press release stating they don’t expect material changes to their budget.
Canadian Equities were strong in June with the S&P/TSX +1.7%. The Fund was +1.6%. Energy was the big story this month, with the sector up 5.4% last month. We are underweight energy but our stock picking was good this month (Enbridge, CNQ and TransCanada were strong) so we actually had a slight positive contribution from the energy sector. The 10 year Canada yields were lower, so this caused Telecom, Utilities and other interest rate sensitives to rally, hurting our relative performance as we are underweight these areas. We added NFI Group and sold Cott Corp and CP Railway. Gold stocks had a strong month and we don’t have any gold exposure in the fund. Top contributors this month were Spin master, Aritzia and Hudson’s Bay. Detractors were Great Canadian, Air Canada and Heroux-Devtek. Covered call writing is at 16% (vs. 19% last month). The target yield on the portfolio (including covered call writing) is 5%.
The NWM Canadian Tactical High Income Fund returned +1.2% in the month which trailed the S&P/TSX’s +1.7% return. The main reason for relative under performance was due to being underweight in energy. Option volatility increased 3.5% in June but is still low relative to its five average; we are still taking a defensive view on the Fund, targeting mid-to-high single digit annualized option premiums while providing good downside protection. Spin Master is a new position in the portfolio.
The NWM Global Equity Fund returned +0.8% vs +0.9% for the MSCI ACWI (all in CDN$). The Fund underperformed the benchmark due to country selection (underweight the U.S. & overweight Japan) and sector selection (underweight healthcare, utilities and energy). Consumer Staples was the best performing sector (+2.7); hence, ValueInvest was a standout performer with >50% of portfolio in Consumer Staple stocks. Performance of our managers in descending order was ValueInvest 2.9%, C Worldwide 1.8%, Lazard +1.2%, Edgepoint +0.6%, NWM EAFE Quant mandate +0.2% (country allocation contributed to performance) and BMO Asian Growth & Income -1.7% (large weight in HK/China >30%).
Last month the NWM U.S. Equity Income Fund was up 0.3% and underperformed the SP500 which was up 0.6%. Our positions in Valero Energy and Carnival and not owning Amazon.com, outweighed our gains in Newell Brands, Accenture, and not owning Intel. In terms of Industry Groups, our underweight in Semiconductors helped, but this was more than offset by our overweight in Banks and being underweight Retailing (Amazon). We sold our positions in Delta Airlines, Pepsi and Disney, and trimmed Comcast. We added to existing Healthcare names United Health, HCA, Thermo Fisher and to our Industrial positions in Aercap and Xylem, as well as to a Materials name, Westrock.
The NWM U.S. Tactical High Income Fund’s performance was +0.5% during the month; whereas, the S&P 500 posted a +0.6% return. The Fund’s slight underperformance was mostly due to being underweight in Consumer Staples (top performing sector) and Healthcare (0% as of month-end vs 14.2% benchmark). Market volatility increased 4.3% in June with the escalation of trade tariffs rhetoric and concerns about weakening global growth. Two new names were added, Molson Coors and Starbucks.
The NWM U.S. Tactical High Income Fund was +1% for the month of June vs. the iShares (XRE) +1.6%. The 10 year Canada rates have dropped from over 2.5% in mid-May to 2.17% at the end of June. If investors have a more muted outlook on rising rates, this may provide a boost to the REIT sector. The outperformers this month were the beaten up retail names SmartCentres and Riocan. Both Riocan and SmartCentres are larger cap so it’s not surprising that they would be the first to benefit as money flows back into the sector. The poorest performer was Dream Industrial as they did a share raise which we participated in. The USD was strong and the fund benefited from the FX as 41% of the fund is invested in MEPT Edgemoor and SPIRE U.S. Limited Partnership.
We report our internal hard asset real estate Limited Partnerships in this report with a one month lag. As of June 30th, May performance for SPIRE Real Estate Limited Partnership was +0.4%, SPIRE U.S. Limited Partnership +1.1% (in US$’s), and SPIRE Value Add Limited Partnership +1.4%.
The NWM Alternative Strategies Fund was up 1.2% in June (these are estimates and can’t be confirmed until later in the month). Winton returned 1.8%, Millennium -0.1%, Apollo Offshore Credit Strategies Fund Ltd 1.5%, Verition International Multi-Strategy Fund Ltd. -1.0%, RPIA Debt Opportunities -0.1%, and Polar Multi-Strategy Fund 0.7% for the month. The strength of Winton’s returns for the month of June came predominately from commodity exposure. Short grains, precious metals and energy futures contributed the most to positive returns while fixed income added 0.4% to returns and short FX resulted in an additional 0.1%. Precious metals stocks were mixed for the month with several positive outliers such as Kirkland Lake Gold up nearly 15%. The NWM Precious Metals Fund returned -0.2% while gold bullion declined -2.2% in Canadian dollar terms.
June in Review
North American equity markets were volatile last month, but positive, with the S&P 500 ending the month up 0.6% (in US dollar terms) while the S&P/TSX was +1.7%. International markets, however, were generally negative, with the STOXX Europe 600 –0.6% and the Shanghai Composite -7.3%, both in local currency terms. U.S. bond yields were a little less interesting and ended the month virtually unchanged, while Canadian bond yields continued to decline, taking the Canadian dollar down with them. In general, the U.S. dollar was stronger against most currencies again last month, and as a result, emerging market securities continued to correct.
SPDR Blog’s 2018 Mid-Year Investor Survey captures many of the issues we believe were impacting markets last month, namely geopolitical and international trade tensions, a slowing of the global economy, and tightening of global monetary policies. Timing for the end of the equity bull market is of course central to all of these. In this uncertain environment one might expect defensive investment strategies to outperform, but this is not the case as “risk on” assets remain in favor. Once we take a closer look at the issues, however, market returns start to make more sense. Well, as much as one can make sense of what is happening in a world where Germany gets knocked out of the World Cup in the first round after losing to South Korea. We’ll start by discussing economic growth and monetary policy before delving into some geopolitical issues and the rising threat of a global trade war.
Despite all the negative headlines investors are bombarded with daily, the fact remains the U.S. economy is actually doing just fine. GDP growth has rebounded, with second quarter GDP growth expected to come in over 4%. Unemployment is well below what the Federal Reserve considers full employment, and inflation has finally reached the central bank’s target rate. The same can’t be said of the Eurozone or the emerging markets, but things in the good old US of A is just fine, thank you.
Sure, growth may slow and Q3 GDP growth won’t match that of Q2. Earnings growth will also likely start to decelerate as the positive impact from tax reform is realized and the strong U.S. dollar starts to weigh down foreign profit growth. We still don’t see any real signs of recession, however.
The real risk for the economy and the markets is interest rates. Bull markets don’t die of old age, but they can be killed by the Federal Reserve and tighter monetary policy. The Fed raised their benchmark Federal Funds rate in mid-June for the second time this year and indicated two more increases are in the cards this year, three more in 2019, and one more in 2020. All these increases are data dependent and will change based on the circumstances at the time, but they do seem a little aggressive and significantly higher than the market is forecasting. The Fed believes the neutral rate, which is the level of overnight rates that would neither be stimulative nor restrictive to the economy, are around 2.875%. Based on its current trajectory, the Fed is projected to hit the neutral rate in 2019 and exceed it by 50 basis points in 2020. Keep in mind, however, this is not an exact science. The Fed doesn’t know for sure what the neutral rate is, or if it’s a static number. It’s a case of the blind leading the blind. Unfortunately, short term bond rates have moved up based on the Feds hawkish rhetoric with two year treasuries trading above 2.5%, but 10 year treasuries have not kept up, initially trading above 3% in April and May, but slipping lower in June. Higher short term rates but stagnant longer term rates has resulted in a continued flattening of the yield curve. A flattening yield curve is not necessarily a negative harbinger for the economy, but if short rates actually exceed long rates and the yield curve inverts, a recession has nearly always followed.
The Federal Reserve is in a tight spot. They don’t want to fall behind the curve, so to speak, by raising rates too slowly and risking the creation of asset bubbles and higher inflation. They would also like to position overnight rates higher such that they have some room to lower them again in the next recession. At the same time, they don’t want to invert the yield curve and tighten monetary policy before the economy is ready for higher interest rates. Since the Fed began raising rates in 2015, it has largely moved up in line with inflation. Real interest rates, or nominal interest rates less inflation, have moved up, but certainly not as much as they did during the 2013 taper tantrum. With inflation finally reaching the Federal Reverses 2% target level, Federal Reserve Chairman Jerome Powell is faced with some important decisions. Higher 10 year yields would relieve some of the pressure on the yield curve and allow short rates to continue moving higher without inverting the yield curve. Whenever 10 year yields move above 3%, however, stocks begin to sell off and bond traders push yields lower. The market doesn’t appear to believe 3% rates are appropriate given the current state of the global economy. The Fed is heading for a showdown with the market. Unless longer term yields move higher, the Fed is not going to be able to increase overnight interest rates as planned without creating a recession.
Also hindering the Fed’s plans are global interest rates. It’s a global market and capital will flow where it finds the best deal. With the rest of the World still flooding the capital markets with liquidity and maintaining overnight interest rates at or even below 0%, capital will continue flowing into U.S. government Treasuries, keeping interest rates in check and the U.S. dollar strong. The ECB, for example, isn’t expected to start raising rates until December 2019. A strong dollar has some negative implications not only for U.S. exporters and multinationals doing business overseas, but is also particularly hard on emerging market economies that export commodities priced in U.S. dollars and/or have issued debt denominated in U.S. dollars. A strong dollar is a result of American economic growth and a diverging monetary policy versus the rest of the developed World and the Federal Reserve needs to be mindful on how far it diverges.
Also helping the dollar is the brewing global trade war. While we would maintain there are no winners in a trade war, some countries are better positioned than others. The U.S. might be one of the World’s top global exporters on an absolute basis, but as a percentage of GDP, total trade (imports and exports) comprises a relatively small portion of the American economy. Not surprisingly, countries more dependent on trade have seen their currencies trade lower against the U.S. dollar, including China, Europe, and Canada. The Chinese Yuan is actually holding its own against most currencies, and has even appreciated against the Euro and the Yen. Only versus the Greenback has the Yuan weakened, indicating its U.S. dollar strength not Chinese Yuan weakness that is driving the currency’s value lower. This is important as it shows China is not devaluing its currency intentionally and using it as a weapon in the developing trade war, at least not yet.
Are currencies correct in indicating the U.S. has the upper hand negotiating a better trade deal? With China, the answer is probably yes. The U.S. bought $375 billion more from China than it sold in 2017, which would suggest they have room to apply tariffs on more imports than China does. The U.S. economy is also strong and the unemployment rate is below what many consider full employment levels. China on the other hand is in the midst of re-balancing their economy away from the export orientated industrial state owned sector and towards more consumer spending, with growth expecting to moderate accordingly. It’s debatable how much pain China is willing to endure at this point, and likely one of the reasons Chinese stocks have been selling off in 2018. With a strong U.S. economy and a weakening Chinese economy, now is the time to confront China on its trade policies, not when the U.S. economy is in recession. China however, does have some cards they can play in the event of an all-out trade war, if they choose to play them. While Chinese exports to the U.S. might dwarf imports, U.S. firms do sell locally manufactured goods in China. Unlike in the U.S., Chinese authorities have the ability to persuade companies and consumers not to purchase non-American brands. This wouldn’t impact the trade deficit, but it would hurt U.S. corporate profits. China has implemented similar strategies in the past against Japan and Korea, which resulted in steep declines in Japanese and Korean auto sales in China. Also, foreign invested firms, including American, produce over 40% of China’s exports, so U.S. corporate profits would suffer if tariffs are increased. Most of these exports are consumer related products as well, so adding more tariffs will increase prices to U.S. consumers.
Reducing the U.S. trade deficit is a worthy goal over the long term, but needs to be implemented in conjunction with a higher U.S. savings rate and a lower government budget deficit. Specifically targeting China’s trade surplus with the U.S. is missing the big picture, particularly given China’s global trade surplus has been declining over the past decade. Curtailing China’s abusive and unfair trade strategies, such as intellectual property theft and government subsidies are a more worthy near term objective, and is largely supported by other developed nations. This is where the real battle should be fought. Already the U.S. is closely scrutinizing direct Chinese foreign investment in U.S. companies, particularly in the technology sector. There was even some concern President Trump would restrict U.S. technology exports to China, which resulted in technology stocks briefly selling off last month before the President appeared to soften his stance. For their part, Chinese authorities have been directed to tone down talk around the Made in China 2025 strategic plan, in which China plans to become a world leader in 10 strategic industries. They are unlikely to shelve the program entirely, however, given it’s central to President Xi’s plan to move China up the manufacturing value chain and avoid the “middle income trap” many developing counties experience as they transition away from a low wage export orientated economy. The recent controversy with Chinese telecommunications equipment company ZTE has likely only increased China’s resolve to become less reliant on U.S. technology after the Chinese multinational was initially handed a seven year ban on buying critical U.S. made components, which would have effectively put them out of business. Only after paying a hefty fine and firing its entire board has the company been given a one month stay of execution as negotiations continue with U.S. law makers. Definitely not a position the Chinese want to find themselves in again.
We also believe geopolitics will play a role in trade negotiations with China. The U.S. wants North Korean nuclear disarmament and requires China’s cooperation in getting it. Perhaps this is what the U.S. got in return for cashing in their ZTE chip? Geopolitics is also likely playing a role in trade negotiations with the Eurozone. The U.S. runs a trade deficit with Germany and Germany runs a massive current account surplus, which makes Chancellor Merkel’s Germany a huge target. Trump has threatened, or more precisely tweeted, the American auto industry has been treated unfairly and the U.S. might apply a 20% tariff on all inbound European auto imports. Trump has a point given American car companies pay 10% tariffs on exports to the Eurozone while European auto companies (which are mainly German) pay only 2.5%, but then Trump typically forgets to mention American tariffs on imported light trucks and vans are 25%, which is where U.S. auto manufactures make most of their profits. German car makers would be fine eliminating all motor vehicle tariffs if it would protect against the threat of the U.S. applying 20% tariffs on German made cars, unfortunately the Germans are unable to strike a deal on their own and have to rely on the EU’s Jean-Claude Junker to strike a deal. Trump also wants the EU to live up to their NATO financial obligations and EU cooperation in dealing with Iran. Both will likely be thrown in the pot during negotiations. Only four of Europe’s 27 NATO members hit the requited 2% of GDP defense spending requirements last year, while U.S. defense spending in Europe has doubled during President Trump’s time in office. Like auto tariffs, there are signs U.S. pressure is starting to have an impact. Eight NATO members are on track to hit the 2% defense spending target this year, and 16 are on a path to get there eventually. Collectively, NATO spending by European members last year, in real terms, hit their highest level since 2010. Europe is getting the message.
While trade and President Trump may dominate the headlines and we don’t want to down play the potential future threat to the global economy, we suspect the poor performance of the Euro and European stocks this year revolves more around disappointing economic growth and political uncertainty in Italy and Germany. A trade war with the U.S. is further down the list of concerns. In the end, a trade deal with Europe should be achievable as a trade war makes no sense.
Which brings us to Canada. Canada has perhaps the greatest exposure to a U.S. trade war given the extent of economic integration we have with our Southern neighbor. Exports comprise nearly a third of Canada’s economy, 75% of which go to the United States. A trade war between the U.S. and Canada, however, makes the least sense. On a goods and services basis, trade is very balanced between the two countries and Canada applies virtually no tariffs on American imports, an average of 0.8% versus 1.6% applied to Canadian goods exported to the U.S. There are fake news charts making the rounds on Facebook and Twitter comparing Canadian tariffs rates on goods like steel aluminum, and copper ranging from 25% to 48% versus U.S. tariffs of 0%, but they are so outlandishly wrong that it’s hard to chalk it up to simply a reporting mistake versus an intentional strategy to deceive. Yes, Canada puts tariffs of 241% on milk imports from the U.S., but only after American importers exceed certain caps. Most imports face no tariffs, and overall, Canada imports more than three times as much dairy from the U.S. as it exports. Both countries protect their dairy farmers. Canada uses a supply management system versus an administrated price set by the U.S. Department of Agriculture that considers regional cost differences. Canada regulates both prices and volumes to ensure the survival of Canadian dairy production, while the U.S. system ensures viable dairy farming is maintained throughout the country. There is nothing to prevent American dairy farmers from ramping up production, which they have done over the past few years, causing prices to crash. They would like to off load this excess to Canadian consumers, which would be good for Canadian milk drinkers in the short term. However, it is not so good if American dairy farmers reverse course and reduce production in the future. Given Canadian dairy farmers would likely be driven out of business by the cheap American imports if our supply management system is scrapped, Canadian consumers would be exposed to potentially much higher prices. But is this really what’s holding up a deal with the U.S. on trade? The U.S. and Canadian economies are so intertwined, it’s hard to see how or why they can be separated. Other than using Canada as a warning to other countries, we don’t get the U.S. strategy. Perhaps China will look at the situation and think, if they are this tough on Canada, they must really be serious?
Like with Europe, other non-trade related U.S. geopolitical issues are also impacting the Canadian economy, but in a favorable way, with the price of Brent Crude Oil up over 2% last month while the U.S. orientated WTI oil benchmark increased nearly 11% and Canadian based Western Canadian Select soared over 26%. Demand for oil has been firm, but the real problem has been supply. Venezuela, which according to the International Energy Agency, lost about 1 million barrels a day of production over the past two years, is likely lose an additional 550,000 barrels a day next year while rebels in Libya have recently closed two ports and taken 850,000 barrels a day off the market. Even Canada is running into supply issues, with the continued shutdown of an important oil facility resulting in a reduction of 350,000 barrels a day in production. The big question being asked last month, however, was how much of Iran’s 2.4 million barrels a day in production will be cut off by the sanctions employed by the Trump Administration tearing up the Iran nuclear deal. Initial estimates were around 300,000 barrels a day, but the Trump administration’s vigor in enforcing the sanctions could move those estimates up closer to 1 million barrels a day, or even higher. The Center for Strategic and International Studies in Washington’s Frank Verrasto estimates the world has about 3.5 million barrels of space production capacity, but how much and how quickly this potential production can ramp up is questionable. President Trump has asked Saudi Arabia to produce an additional 2 million barrels a day. While this is theoretically possible, even the Saudis would have trouble ramping up production this quickly, even if they wanted to. As a result, oil prices could spike materially higher. Sanford Bernstein analyst Neil Beverridge recently highlighted the lack of industry investment in finding new reserves has left the market vulnerable to a “super-spike” in prices that could push crude prices much higher than the $150 a barrel peak reached in 2008. This would be good for the Canadian oil sector and likely help buoy the Canadian dollar, but would be catastrophic for consumers and would push inflation higher. This is bad timing for a global economy facing a potential trade war. Increased globalization has helped lower prices over the past four decades. Global exports have started to decline this year, however, and a trade war would see this trend accelerate. In this environment, it would be reasonable to assume the benefits of globalization would be reversed and price inflation would increase.
There are lots of unknowns in the World today, and from that perspective, investors should expect markets to remain volatile. Based on what we know today, however, the strength of the U.S. economy should help keep U.S. stocks and the U.S. dollar moving higher. This is why risk assets remain in favour and equities continue to move higher. Not all risk assets, however, asthe synchronized global economic recovery we saw developing last year has stalled. Fueled by tax reform and strong job growth, the U.S. economy continues to gain momentum and has separated itself from the pack. We see this differentiation in the equity markets. Not only have U.S. stocks performed better than their foreign counterparts, but smaller U.S. stocks that are more exposed to the domestic U.S. economy, such as those in the S&P Mid Cap 400, the S&P Small Cap 600, and the Russell 2000, have performed better than the larger multinational companies that dominate the S&P 500 and the Dow Jones Industrial Average.
In this environment, the U.S. is in a more favorable position to endure and survive a trade war, and the capital markets appear to agree. We remain hopeful capital spending will provide the next leg upwards for the U.S. economy to continue to expand, but we also see risks that could bring the current business cycle to an abrupt end. Higher interest rates, trade wars, higher oil prices; these are all threats to the current economic cycle, and are very hard to forecast. We believe tariffs are being used as a negotiating tool and an all-out trade war will be avoided, but the risk cannot be dismissed, particularly in regards to China. Nor can the risk of higher oil prices and its impact on the business cycle. Now is not the time for investors to become complacent. Risk assets are still attractive, but investors need to start working on a Plan B.
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 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. 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 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. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.