Market Commentary: How much further can this bull run?


By Rob Edel, CFA

Highlights This Month

 

 

Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were up 1.3% in the month of March and +4.2% for Q1/19.  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 March, and is +2.2% for the first quarter of the year. General bond market returns benefited from both tightening investment grade credit spreads and falling government interest rates. With the U.S. Fed putting the brakes on tightening monetary policy for now, we have lengthened duration slightly. But we continue to have a high credit grade bias, as Canadian investment grade credit spreads have moved back to historically narrow levels. The Nicola Bond Fund currently has a net yield of 3.2%.

The Nicola High Yield Bond Fund returned +1.1% in March, and is +2.4% year-to-date. The ICE BofAML US High Yield Index extended its 2019 gains by +1.0% in March, after the U.S. Fed’s halt on monetary policy tightening. The event created immediate market expectations for resurgent chase-for-yield fund flows for high yield credit, outweighing any related economic slowdown concerns. The BoAML US High Yield Index yield has reverted from its year-end high of 8.0% down to 6.5%. The Nicola High Yield Bond Fund currently has a net yield of 5.0% and duration of around two years.

The Nicola Global Bond Fund was +0.7% for the month.  The Nicola Global Bond Fund benefited from U.S. dollar strength (+1.3% vs CAD$) and credit compression in high yield and investment grade credits.  Emerging markets currencies detracted from performance with weakness in the Latin America (Argentine Peso, Brazilian real and Columbian). Our underlying managers’ duration exposure was mixed with PIMCO long U.S. & Australia duration while Templeton was short U.S. duration.  Performance of our managers in descending order: PIMCO Monthly Income +2.3%, Manulife Strategic Income Fund +1.6% and Templeton Global Bond -0.1%

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 5.5% for the Nicola Balanced Mortgage Fund.  The Primary fund had 23.3% cash at month end, while the Balanced had 12.1%.

The Nicola Preferred Share Fund returned -1.7% for the month while the BMO Laddered Preferred Share Index ETF returned -0.9%.  Weaker returns were mainly driven by the five year Bank of Canada bond yields moving 30 basis points lower. Rate reset preferred shares reset their yield based on five year Government of Canada bonds, so they are negatively influenced by bond yields moving lower. Yields relative to corporate bonds remain attractive and there are signs that retail sentiment may be changing as demand for preferred shares picked up in the ETF space with over $50 million of new money that bought into ETF’s. That being said, March marked record highs for short interest for two of the largest preferred ETF’s.

Investors short investments hoping to profit by a decrease in their value. The shorting appears to be driven by U.S. based hedged funds who believe that the Canadian housing market will crash and Canadian banks will suffer a similar fate to their U.S. counterparts. Canadian bank preferred shares can be converted to common equity, but for this to occur the Office of Superintendent of Financial Institutions (OSFI) needs to deem a bank to be in such severe financial difficulties that they are deemed non-viable. Although the housing market in parts of Canada are very expensive, Canadian banks have more strict lending requirements and haven’t engaged in the same aggressive sub-prime lending practices and therefore, we are not concerned about the viability of Canadian banks.

The S&P/TSX was +1.0% while the Nicola Canadian Equity Income Fund was -0.3%. Consumer Staples and Energy were positive contributors. But the negatives outweighed the positives this month as the top detracting sectors were Consumer Discretionary, Industrials and Information Technology. We do not have exposure in Information Technology where valuations are high and value is slim. We added Park Lawn to the portfolio in March. Park Lawn owns and operates a number of cemeteries and funeral homes in both Canada and the US. Top contributors to performance were Aritzia, Maple Leaf Foods and Interfor. Top detractors were Spin Master, Great Canadian Gaming and Cargojet.

The Nicola Canadian Tactical High Income Fund returned -0.3% vs the S&P/TSX’s +1.0%.  The Nicola Canadian Tactical High Income Fund’s relative under performance was due to being underweight (0%) Info Tech, Real Estate and Utilities, and stock selection within consumer discretionary and industrial sectors.  As the market continued to move higher, the market participants became more complacent and less concerned about market risk as shown by the continued decline in Canadian option volatility index (-2.7% for the month).  The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 69% (slightly higher than the last two months) and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market.  No new names added, but we did add to our Bank of Nova Scotia position.

The Nicola U.S. Equity Income Fund returned +2.1% (USD) while the S&P500 returned +1.9%.  An underweight in Consumer Discretionary and stock selection from Carnival and U.S. Banks were drags on performance; however, this was more than offset by owning NVidia, Costco, Accenture, and Crown Castle.  Two defensive names were added: Hormel and Nextera Energy Partners; this was funded by trimming positions in the Materials sector, namely Sherwin-Williams, Vulcan Materials, and DowDuPont.

The Nicola U.S. Tactical High Income Fund returns +0.7% vs 1.9% for S&P 500.  The Nicola U.S. Tactical High Income Fund’s relative underperformance was mostly due to being underweight Info Tech & Real Estate and stock selection within Consumer Discretionary and Financials.  Option volatility decreased 7.2% during the month to sub-14 volatility which puts it back to Q3 2018 levels.  The Nicola U.S. Tactical High Income Fund’s delta-adjusted equity decreased from 52% to 50%.  The portfolio remains defensively positioned with a lower valuation multiple, and higher free-cash-flow and lower leverage relatively to the S&P 500.

The Nicola Global Equity Fund returned +2.7% vs +2.9% for the MSCI ACWI (all in CDN$).   While our overweight in the defensive Consumer Staples sector was accretive to performance, this was offset by our exposure to small cap and being underweight the U.S.  Performance of our managers in descending order was: CWorldwide: +5.3%, BMO Asian Growth and Income: +3.5%, ValueInvest: +3.1%, Nicola EAFE Quant: +2.4%, Edgepoint Global: +1.4%, Lazard Global Small Cap: -0.2%.

The Nicola Global Real Estate Fund was +1.9% for the month of March vs. the iShares (XRE) +3.6%. Currently, 36% of the fund is allocated to U.S. denominated LPs. Publicly traded REITs make up 24% of the fund which is near the low end of our range. In our view, the most attractive sectors in terms of fundamentals are Apartments and Industrial and have tilted the portfolio towards those areas where demand appears the strongest. We also find the growth compelling in the Self-Storage sector and added StorageVault Canada to the portfolio in March.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of March 29th February performance for the Nicola Canadian Real Estate LP was +2.1%, Nicola U.S. Real Estate LP +1.0%, and Nicola Value Add LP 1.2%.

The Nicola Alternative Strategies Fund returned 1.5% in March (these are estimates and can’t be confirmed until later in the month).  Currency contributed 0.9% to returns as the Canadian dollar weakened through the month (-2.1%). In local currency terms, Winton returned 0.9%, Millennium -0.2%, Apollo Offshore Credit Strategies Fund Ltd 1.0%, Verition International Multi-Strategy Fund Ltd 0.2%, Renaissance Institutional Diversified Global Equities Fund 1.5%, RPIA Debt Opportunities 0.7%, and Polar Multi-Strategy Fund 1.1% for the month. Return drivers for the different strategies were well balanced with only Millennium detracting from returns for the month.

The Renaissance Institutional Diversified Global Equities fund (RIDGE) had strong returns after beginning the year with flat returns for the first two months. The fund employs quantitative strategies based on specific factors which should drive positive long term returns. One of the predominate factors is a focus on quality companies, companies that generally are less volatile with less beta than the underlying market. A normal, stabilized market highlights this strategy which shares characteristics with Aesop’s “The Tortoise and the Hare” fable as solid, high quality, sometimes boring companies often outperform their more flashy peer group.

The Nicola Precious Metals Fund returned -2.7% for the month while underlying gold stocks in the S&P/TSX Composite index returned 3.3% and gold bullion was lower -0.3% in Canadian dollar terms. Despite the weaker returns in our fund, we believe that the outlook for gold has brightened and the strategic case for an allocation to gold has strengthened. Increased geopolitical risk, mounting government debt, and a flat Treasury yield curve are conditions favorable to gold which has historically been a safe haven and reserve asset, geopolitical hedge, and diversifier for portfolios. Merger and acquisition proposals amongst large gold companies impacted returns for the month. Following Barrick’s merger with Randgold Resources late last year, Barrick made a hostile bid for Newmont before retreating with a potential joint venture proposal while Newmont looks to continue with a potential merger with Goldcorp. The M&A activity caused large dispersion amongst gold companies for the month with smaller firms lagging behind their larger counterparts. During the month TMAC Resources, Guyana Goldfield, Kirkland Lake Gold, Dacian Gold in Australia all struggled with double digit pull backs.

 

March in Review

Markets were strong again in March, with the S&P/TSX +1.0% and the S&P 500 +1.9% (in U.S. dollar terms).  By not falling below its December 24th low and triggering a bear market by declining more than 20%, the S&P 500 bull market remained intact and turned a record 10 years old on March 9th.

Already the longest on record, and counting, attention continues to focus on how much further this bull can run.  All this attention comes with a few asterisks, however.  First, Yardeni Research believes the longest bull market is actually the 1987 to 2000 rally which lasted over 12 years, though most still believe a 19.9% correction in 1990 interrupted this otherwise record run in stocks.

Even if one classifies the 1990 correction as a bear market, thus ending the 1987 at a mere three years, the ensuing 3,462 day run from October 1990 to March 2000 was still the longest in history until the current bull market eclipsed it last August.  But according to Bloomberg Opinion columnist Barry Ritholtz (our second asterisk) the current Bull market isn’t as old as most market analysts believe given the rally didn’t start with the Bull Market low on March 9th, 2009, but rather on March 28th 2013 when the S&P 500 took out the previous pre-crisis high of October 9, 2007.  If this is the case, the current bull market has about another four years to go before it can claim top spot.

Even if one were to conclude the current rally is the longest in history, it is still not the best performing, ranking below both the 1990 to 2000 and the 1932 to 1937 bull markets.    We don’t want to spoil the party so we’ll just say “Happy 10th Birthday S&P 500” and move on.

    • March has one of the most unloved rallies in history

      Less concerned with birthdays and milestones, we are more concerned with what comes next.  Returns in March were generally strong across the board for the month, not just in the S&P 500 and S&P/TSX, but globally.  And not just in stocks, bonds, credit, and commodities all performed well.

      First quarter performance for the S&P 500, in fact, was its best since September 1998 (as of March 29th) while High Yield Bond returns of over 7% were the highest since 2003 and investors would have needed to go back to 1995 to beat the nearly 5.25% returns delivered by U.S. investment Grade Credit.

      Despite these returns, and the absence of a 20% plus correction over the past 10 years, this bull market remains one of the most unloved rallies in history.  According to Strategas’ Jason De Sena Trennert, individual investors have actually been net sellers and Fundstrat’s Thomas Lee recently commented most Hedge Funds are either short stocks or have their lowest exposure in years. According to data compiled by Bloomberg, money market net assets remain at their highest levels since 2010.

    • Investors remain cautious of trade wars, global growth and monetary policy 

      Why are investors so cautious?  Not only is the current bull market the longest ever at over 10 years, but this summer the current economic expansion will also celebrate its 10th birthday, which would also be a record in longevity.  Surely we have to be getting closer to the end of the current business cycle?  As the old market adage states, however, bull markets and expansions don’t die of old age.  Just look at Australia, which has been riding the wave of expansion for 28 years and counting. Discounting longevity then, perhaps a more specific list of concerns can be found in a recent investor’s survey by RBC U.S. Equity Analyst Lori Calvasina, and low and behold recession risk/end of the cycle is listed as one of the top concerns. Trade wars, global growth and monetary policy also hit the list in some shape or form.  All deserve a little more attention and commentary this month.

  • Bond prices are unusually rising at the same time as stocks 

  • One of the most interesting aspects of the rally last month was its breadth, with nearly all asset classes registering positive gains.  It’s unusual for bond prices to move higher at the same time as risk assets, like stocks, are rising in price.  Stocks typically move up with stronger economic growth, while bond prices should move in the opposite direction as yields move higher (and prices down) in order to discount higher expected inflation.  Credit spreads should contract as the economy expands, driving corporate yields lower and prices higher, but not government bond yields.  Lower government bonds yields, in fact, are a signal the economy is in trouble and there is an increased risk of a recession.  Case in point, German 10 year bond yields actually went negative last month for the first time since October 2016.  With yields falling, the bond market appears to be flashing a warning signal the equity and credit markets look to be ignoring.
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    • The Bond market was reaching to global growth, which has been trending dangerously lower.

      The IMF recently lowered their forecast for global growth this year to 3.3%, its lowest level since 2016, citing increased trade tensions between China and the U.S. as a contributing factor.  Declining business confidence, tightening financial conditions, and higher policy uncertainty were also listed by the IMF as areas of concern.  Lower first quarter GDP estimates and declining leading indicator indices in the U.S. confirm the American economy is not immune to the decline in global growth.

      A strong job market and resilient consumer confidence, however, mean a recession is unlikely.  U.S. manufacturing has weakened, but only off high levels with purchasing manager indices remaining well in expansionary territory.  Employment growth remains strong without wage inflation moving materially higher and general inflation below the central bank’s 2% target means there is still room for the economy to expand without overheating.  Overall, a goldilocks environment, not too hot or too cold.  Slower growth, yes, a recession, not yet.

      Same for earnings.  Corporate profits won’t be as strong as last year, and they might even decline in the first quarter, but in general, corporate America is in good shape.

    • Slowing growth in Germany is a concern given its importance to the Euro-zone economy. 

    • Europe is a different story.  The IMF was particularly hard on the Euro-zone, singling out Germany and Italy as significant underperformers.  Slowing growth in Germany is a concern given its importance to the Euro-zone economy.  German purchasing manager indices plummeted to seven year lows last month, well below the 50 level, indicating the manufacturing sector in the World’s largest exporter is contracting.  This was a disappointment to the market since earlier in the month it looked as if economic growth in the Eurozone was starting to improve, with positive economic surprises outpacing the U.S. and Asia Pacific.  The recent improved purchasing manager numbers out of China are more encouraging, however, as Eurozone manufacturing tends to track China’s with a three month lag.

 

    • Improved Chinese manufacturing numbers are good news for global economic growth.
    • Improved Chinese manufacturing numbers was one of the factors helping buoy sentiment last month, as signs the world’s second largest economy might be stabilizing is good news for global economic growth.  The fallout from a planned crackdown in shadow bank lending and a general deleveraging strategy by the central government was probably greater than expected and efforts have since been made to encourage banks to extend credit to non-state owned enterprises.Fiscal stimulus should also help bolster growth, with tax cuts and greater deficit spending announced last month.  Of course, a trade deal with the U.S. would also help business confidence, in both countries.  Talk that a deal is close, and in the words of President Trump “will be monumental” have helped settle investor nerves, but there are still hurdles to overcome, like the framework for some kind of enforcement mechanism. Fingers crossed, hopefully Chinese economic growth can get back on track.

 

    • Fed unlikely to raise interest rates this year
    • Along with positive Chinese manufacturing numbers, the other positive market catalyst last month was news from Federal Reserve Chairman Jerome Powell the Fed was unlikely to raise interest rates this year, and could be close to the end of their current tightening cycle.  Markets suspected as much already, but confirmation predictably ignited speculation on whether the Fed was now going to lower rates, with a 25 basis point cut now being discounted in the futures market.  In reality, financial conditions in the U.S. are still quite stimulative, with the Goldman Sachs Financial Conditions Index actually lower (meaning financial conditions are looser) than when the Fed started raising rates in early 2016.  Only until just recently have short term interest rates exceeded inflation, meaning real interest rates have actually been negative.  We wouldn’t go as far as to say investors have been able to get money for nothing, but pretty close.

 

    • Future rate hikes are on hold, potentially indefinitely
    • Low inflation and concerns over slower global growth led the Fed to put future rate hikes on hold, potentially indefinitely.  The market reaction was swift, with rates falling across the yield curve, with the exception of the short end anchored by the Federal Reserve and their intention to remain patient.With three month rates unchanged and 10 year yields falling over 30 basis points in the month of March alone, the 3 month versus 10 year yield curve inverted for the first time since 2007.  An inverted yield curve has preceded every U.S. recession since 1975 and a model developed by the New York Federal Reserve based on the 10 year versus three month yield curve currently pegs the odds of a recession at over 27%.  Historically, only once, in 1999, did a recession fail to materialize once the model probability exceeded 24%.  The model has a perfect record above 28%.  Markets reacted poorly to news of the inversion.
    • There are a number of mitigating circumstances to this inversion being an imminent harbinger of a recession, however.  First before previous recessions, inversions in the three month/10 year yields have lasted for months.  This current inversion lasted only about a week and by the end of March the 10 year yield was back above the three month rate.  Also, while it is true the three month/10 year inversion has a perfect track record since 1975, it did miss inverting before six recessions from 1935 to 1960 and delivered a false positive signal in 1966 when the yield inverted but there was no recession.

 

    • The entire yield curve hasn’t inverted, with the much watched two year versus 10 year yield curve is still positive. 

      In fact only about 40% of the U.S. yield curve inverted while at least 70% has inverted prior to past recessions.  From 3 years out, the yield curve is still positive, and actually steepened in March, not what one would expect in a normal pre-recession inversion.

      Another more technical explanation why the current inversion may not be as good a predictor of a recession as with past inversions is due to something called term premium.  Term premium is the extra compensation investors require in order to compensate for the inflation risk they bear when investing in longer term bonds.  Reflecting a generally benign view of future inflation, term premium is presently negative, thus resulting in a flatter yield that is much more susceptible to inverting, particularly given central bank buying from past quantitative easing programs has further compressed yields.  According to J.P. Morgan’s rates strategists, the Fed’s larger balance sheet could be helping to flatten the yield curve by as much as 40 basis points.

      The magnitude and duration of last month’s inversion leaves us skeptical a true recession signal has been triggered.  Even if this were the case, however, J.P. Morgan’s Strategy and Quantitative Research group recently pointed out investors have historically enjoyed above average equity returns for periods of up to 30 months after an inversion.

      Helping returns is the fact central banks tend to stop hiking or commence cutting, which is beneficial to equity valuations.  While the futures market is currently predicting rate cuts, we’re not so sure the next move by the Fed will be a cut.  Officially, the Fed is still leaning towards a 25 basis point hike in 2020 as their next move while many, including President Trump, believe the Fed should cut by 50 basis points.  The market thinks the Fed will cut 25 basis points in 2019, and according to Société Générale this is an important recession indicator.  Over the past 30 years, the market has switched from pricing in a rate hike to a rate cut during a hiking cycle six times.  Only on the three occasions where the market priced in a rate cut in excess of 100 basis point did a recession follow.  So far, the market is nowhere near pricing in a 100 basis point cut, another reason why we don’t think the inversion is correctly forecasting a recession.

 

    • The prospects of a trade deal between U.S. and China helped markets move higher

    • The prospects of a trade deal between U.S. and China helped markets move higher, but the real catalyst remains the Federal Reserve’s pivot away from continuing to raise interest rates.  Low inflation and slowing global growth provides the cover needed to keep rates where they are, but growth will likely need to slip even further in order to justify a cut.
    • Alternatively, if growth stabilizes, Central Banks could feel renewed pressure to continue raising rates.  It’s a fine balance with Fed and markets stuck in a bit of a box.  Growth is good for earnings, but bad for interest rates and valuations.
      Even slower growth is good for valuations, but not so good for earnings.  Of the two, we’ll take better growth and take our chances with higher rates

 

  • We don’t see a recession this year, or maybe even next.

  • We don’t see a recession this year, or maybe even next.  Growth may slow, along with earnings, but we just don’t see tangible signs of a recession in the real economy, yield curve or not.  Valuations have moved up to reflect this, however, so returns over the next few months could remain restricted.
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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.