Market Commentary: A Split Decision at Best


By Rob Edel, CFA

 

Highlights this Month

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October In Review 

October was again a risk-off month for most equity markets, with the S&P/TSX index falling 3.1%, the S&P 500 -2.5%, and the MSCI ex US All Cap World Index -1.9% (all in Canadian dollar terms). Like we saw last month, however, cyclical and value stocks trended higher, while growth-orientated names appeared to bear the brunt of the selling.

The tech-heavy Nasdaq 100 fell almost 3.0% while the Russell 2000 Value index actually ended the month in the black, gaining 2.3% (all in Canadian dollar terms). When there is a rotation away from growth and into value, and more cyclically orientated companies, it can be a positive signal if it is a result of traders positioning their portfolios in anticipation of stronger economic and corporate earnings growth.

In addition to the economy and corporate earnings, there were a number of issues weighing on the market, not the least of which was the fiscal stimulus, or more precisely the lack thereof. As it has been for most of the year, the biggest concern continues to be the pandemic, though with the US general election taking place November 3rd, much attention was diverted towards what was happening at the polls.

The 2020 election is on track to exceed expectations in terms of uncertainty.

Probably the most highly anticipated election in recent memory, the question of who would become (or remain) President had the potential to move markets in a year when big news stories have become the norm, and it didn’t disappoint. While perhaps not providing the magnitude of swings in the markets as the 2016 election, the 2020 election appears on track to exceed expectations in terms of the duration of uncertainty. Because of the outcome, when reviewing results from last month we will look at events both leading up to the election, as well as market action following the results as we know them now, which we fully acknowledge is a moving target.

2020 has been an exceptionally tough year and global economic growth could take years to recover. According to the IMF, 5-year growth rates for most economies post the pandemic is forecast to be materially lower than before the pandemic with spare economic capacity remaining in place for at least the next few years. The gain of an extra hour of sleep as clocks fell back last month appeared to only prolong the agony.

The US economic recovery.

For the US economy, Q3 GDP growth appears to confirm a V-shaped recovery with a record 7.4% quarter over quarter increase going a long way to offsetting Q1 2020’s 9% contraction. In order to get back to levels the economy was trending towards before the pandemic, however, GDP would need to grow at a robust 4.5% annual rate over the next nine quarters. This is a tall order, especially given a recent WSJ article argues most of the growth reported in the third quarter actually took place in May and June after the economy had bottomed in the second quarter. Evidence the recovery is slowing can also be seen in the job market, which is still 10 million workers short of where it was before the pandemic.

Beneath the headline numbers, signs of an uneven recovery and growing inequality point more towards a K-shaped recovery rather than the optimistic V shape, with some segments of the economy recovering quite nicely, while others remain very depressed. Cities, for example, are taking longer to recover back to normal activity versus rural areas. Goods manufacturers have rebounded quicker than service orientated businesses, and job losses have been less severe for higher wage earners.

Generous unemployment benefits were part of an unprecedented series of fiscal stimulus/aid packages designed to help bridge the gap for many businesses and lower-wage earners, but with many programs set to expire in the summer, more stimulus is urgently required. After quickly approving three deals worth about $3 trillion, it was expected the normally dysfunctional Congress would be able to put politics aside and approve more fiscal relief before the election. They were not. As time ran down, markets traded based on the latest hope Democrats and Republicans could put aside their differences, only to have their hopes dashed as Democratic demands for a larger package that included relief for cash strapped States, were met with cynical Republicans who felt less stimulus was required and Democrats were using the negotiations for their own political advantage. Markets were not amused.

The good news was many felt it was not a question of if, but when. Once the Democrats took control of Congress and Biden became President, a stimulus package would be passed, and it would be big. We still believe a package will be passed, but the timing and magnitude are still very much up in the air. House leader Nancy Pelosi might have overplayed her hand in seemingly pulling the football away from President Trump and Senate Republicans one too many times.

The two main reasons the markets were weak last month.

The failure to secure another fiscal stimulus package was one of the main reason’s markets were weak last month. The other was the virus and the worrying trend of higher infection rates. In both Europe and North America, a second wave (or even a third wave for some US cities) appears to be forming as infection rates inflect higher and hospitalization and death rates forecast to follow, with a lag. This is not a surprise. Most forecasts predicted a resurgence would happen once temperatures turned lower, with Goldman Sachs recently building a case cold weather and higher infection and hospitalization rates were strongly correlated and could lead to super-exponential growth rates.

Despite concerning COVID-19 trends, a slowing economic recovery, and a failure by Congress to pass another fiscal stimulus bill, markets remain remarkably upbeat. Yes, markets have traded sideways the past couple of months, but more investors are bullish and few are predicting another significant drop over the next few months.

Corporate earnings have been stronger than expected.

In fairness, corporate earnings have been stronger than expected, with Morgan Stanley reporting 82% of companies announcing earnings beat estimates with overall earnings coming in 18.7% above consensus estimates. The extreme uncertainty of the lockdowns and its impact on corporate America certainly set the stage for the large beat and earnings are still expected to be down about 10% compared to the same period last year, but it is still a positive sign. Things are not as bad as we thought they were going to be a few months ago. Investors have started to set the bar higher, however, punishing those few companies still missing forecasts, and largely ignoring those that beat on earnings and sales.

Rather than earnings, what the market was really focussed on was the November 3rd US election. Leading up to the election, markets were bracing for a “Blue Wave” outcome, with Democrats taking control of both the Senate and the House of Representatives, and Joe Biden becoming President. Despite implementing a generally business-friendly agenda, even Corporate America had distanced themselves from the Trump Administration, with even many Republicans beginning to worry an economic recovery was at least a year away and President Trump’s policies were hurting, not helping the economy. A bad sign for a President who has historically judged his success based on the strength of the economy. Not surprisingly, a pre-election poll of institutional investors conducted by Strategas found a Democratic sweep was deemed to be a bigger threat to the equity rally than a second Covid-19 wave.

Investors were concerned about the higher corporate taxes and increased regulations a Democratic sweep might bring, but voters recognized the benefit higher government spending could have on economic growth in the short term, and the need to control the pandemic and the health risk it presented. At least that was the belief by much of the media and pollsters. What was perhaps being missed was that while Democrats based their campaign platform on the need to control the pandemic, many voters were more worried about their jobs and law and order. As was the case in the 2016 election, Democratic policies appealed to educated urban office workers living on the coasts, but displaced factory workers in the so-called flyover States were largely forgotten. How a billionaire real estate developer from New York City became and remained their advocate versus the more progressive wing of the Democratic party remains a mystery, certainty to the Democratic Party anyways.

The feared blue wave ended up being a ripple.

While President Trump was indeed not re-elected, the feared Blue wave ended up being more of a ripple. Though the results as we write are not final, Joe Biden is projected to easily win the electoral college and the popular vote. With a margin in excess of 5 million, the Washington Post pegs Biden’s popular vote total at a record 77.3 million, and at 50.8%, the highest percentage any challenger has accumulated against an incumbent President since Roosevelt defeated Hoover in 1932.

Still, it is expected 72 million Americans voted for Trump and as Strategas pointed out, a mere 70,000 votes in the hotly contested swing states of Pennslyvania, Arizona, and Georgia determined the winner. According to political commentator Bruce Mehlman, seven States were within a 3% margin and a swing of under 40,000 total votes from Biden to Trump spread between Pennsylvania, Georgia, and Wisconsin would have flipped the result to a Trump victory. On election night, it looked like the Donald had actually pulled it off and was on the road to a 2016 style upset as Florida failed to vote as the polls predicted and Texas remained Republican red.

Perhaps more disappointing for the Democrats than a tight Presidential race was what happened down-ballot. Democratic hopes of taking control of the Senate now appear unlikely. Georgia’s two Senate seats were too close to call and will require a January 5th runoff election. Democrats will need to win both in order to create a 50-50 tie, which Vice-President-elect Harris would serve as a tiebreaker, thus giving Democrats control.

Most experts don’t think both seats will go Democrat, however, leaving Republicans in control of the Senate. The biggest surprise, however, was in the House of Representatives, where instead of adding to their majority, Democrats lost a net five seats. They still have the majority, but it’s not the comfortable margin they had hoped for. Tally it up, Democrats won the Presidency, but it was closer than many predicted, they failed to win the Senate, and they lost ground in the House. Call it a split decision, at best.

Which makes sense given the two major issues leading up to the election, the pandemic and the economy, we’re also split. More Democrats cared about the virus, which Trump badly mishandled, while Republican voters were focused on the economy, on which they felt Trump has done a good job. As a result, President-elect Biden will become the first incoming president since George HW Bush in 1989 to take office without his party controlling Congress, and the first Democratic President since 1885 to not have control of the Senate. This leaves Biden with a very weak mandate to make any material changes or even pick his Cabinet, which requires Senate approval. Gridlock will be likely in Washington until at least the 2022 Midterm elections.

Of course, we are maybe jumping the gun a bit. As of mid-November Present Trump has still not conceded, claiming voter fraud and plans to use the courts to overturn the results in his favour. We view this risk as quite small. While a contested election was many forecaster’s worst-case scenarios, so far the election process has gone relatively smoothly without any violent demonstrations. Trump’s legal challenges appear to be without merit, and it is likely Republican Congressmen and women are humouring him more than they are supporting him.

With control of the Senate is up for grabs, Republicans still need Trump and his loyal supporters help in Georgia. The Donald still has widespread support, and no one wants that support directed against them. Trump is unlikely to fade (willingly) into the background any time soon. With over 80 million Twitter followers, Trump will be looking to keep his brand alive and monetize it as best he can.

Privately there is talk of a Trump news channel or even the possibility he could run again in 2024. With over 70 million votes, Trumpism has a following, and the Donald is their spokesman. In the meantime, while he may be a lame duck, Trump remains President until January 20th, which might keep the markets on edge given his unconventional and unpredictable nature. Rather than ensure a smooth transition to Biden, the Donald appears motivated to make it as confrontational as possible. Should be we have expected anything less?

For the markets, the prospect of political gridlock is not a bad thing.

Market action after the results started rolling in to tell the story. The broader market rallied, with the S&P 500 up to over 2% the day following the election, but not all sectors went up. Financials lost ground, as did Utilities, Industrial, and Materials, as hopes of a big fiscal stimulus package spurring short term economic growth began to fade. Health Care rallied as fears of an industry destroying Medicare for all move to become more remote. Like Technology, Health Care stocks also benefit from an environment of slow growth and low-interest rates, which gridlock and no big stimulus package would bring. With gridlock, it is also unlikely Biden will be able to raise corporate taxes, but he might decide to take a different strategy in regards to trade and reduce or eliminate tariffs.

Gridlock is also good for the bond market. Before the election, fears of a blue wave and more government spending was causing the yield curve to steepen and inflationary expectation to rise. With gridlock and lower deficit spending and potentially slower growth, inflationary expectations fell and 10 and 30 year Treasury yields declined.

While we view these short term market moves as valuable indicators of what traders believe might unfold, what the pandemic does will likely have a greater impact on the market than what happens in Washington. Without a vaccine, no one can control the virus, and markets are dependent on the Federal Reserve to keep markets liquid and interest rates low.

And when might we see a vaccine? This is the question everyone is asking. With infection rates rising and more restrictions likely to follow, the economic recovery could stall and inflict real long term damage. The best-case scenario would see a vaccine widely distributed next year such that herd immunity is reached by late summer. If this starts to materialize, expect some of the pre-election blue wave market action to reassert itself, with longer-term interest rates increasing and cyclical sectors outperforming. The fiscal stimulus wouldn’t be the driver, but the effect would be the same. Right now it’s a battle between the Pandemic and the damage a second wave might inflict, especially without more fiscal stimulus, versus the possibility we get an effective vaccine quicker than expected. More on this next month.

Nicola Wealth Investment Returns

Returns for the Nicola Core Portfolio Fund were -0.3% in the month of October. 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 0.5% in October. The Nicola Bond Fund was up approximately 0.6% mid-month before volatility returned to the market causing spreads to widen and a mild retracement. The muted sell-off in fixed income mirrors recent activity in the marketplace where credit spreads have been benign during periods of equity market weakness. This can likely be attributed to both technical and fundamental factors. The Nicola Bond Fund continues to be strongly positive in the space, central banks remain supportive, and many companies have extended-term with significant issuance year to date. We anticipate these supportive measures to remain and do not envision large drawdowns in the near future. Nonetheless, we took the opportunity to take profits in our overweight positions in Marret and East Coast and reduce our credit exposure. Credit spreads have tightened significantly since March. Within the last 12 months in Financials, we have seen a rage of 71-261 bps in terms of spreads. Currently, we are sitting at 89 bps and we do not believe that there is not a significant upside to further credit spread tightening.

The Nicola High Yield Bond Fund returned 0.6% in October. Credit spreads remained relatively resilient in the high yield space despite a sell-off in equity markets during the second half of the month and significant outflows in the high yield market by retail investors as they looked to de-risk. Recently we initiated a position in the convertible bond market, we funded this purchase with proceeds from PH&N High Yield Bond Fund. This month, we reduced our beta exposure by reducing our position in Oaktree to replenish PH&N. We continue to be selectively opportunistic in the high yield space. We are underweight both extremes of the market, attractive industries such as wireless telecommunications have seen spreads tighten too much and look expensive at the moment while COVID related industries trade at more distressed levels but the lack of clarity on resolution means we have treaded carefully in these sectors and as such we have focused more in the mid part of the high yield market with select exposure to names where there is a catalyst driven outcome.

The Nicola Global Bond Fund was up 0.2% for the month. The strongest performing strategy for the month was the BlackRock Securitized Investors fund which was up nearly 2% for the month. The securitized market remains attractive particularly non-agency mortgages as investment-grade companies are projected to keep increasing corporate leverage while homeowner leverage remains low. Pimco Monthly Income Fund has increased exposure to more defensive positions by increasing duration in the portfolio while also increasing exposure in Agency mortgages backed securities. With lower yields globally, having the flexibility to be tactical is more important than ever. If volatility picks up, we expect Pimco to pivot and redeploy into risk assets to take advantage of better pricing.

The returns for the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund were +0.3% and +0.4% respectively in October. The majority of COVID-19 related payment deferrals have now completed, with just one loan in the Nicola Primary Mortgage Fund and one loan in Nicola Balanced Mortgage Fund remaining affected by the economic impacts of COVID-19, compared to 2 in each fund in September.

The remaining COVID-19 impacted loan in the Nicola Primary Mortgage Fund is in default, and we are optimistic that the loan will be repaid in full. We continue to review new investment opportunities for both the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund, with a large pipeline of loans under review at the month-end. An active month for trading, there were large buys of the Nicola Balanced Mortgage Fund in particular, which contributed to elevated cash levels of 21.3% at month-end compared to 13.6% in the  Nicola Primary Mortgage Fund. Current annual yields, which are what the Nicola Balanced Mortgage Fund and the Nicola Primary Mortgage Fund would return if all mortgages presently were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.1% for the Nicola Primary Mortgage Fund and 5.3% for the Nicola Balanced Mortgage Fund.

The Nicola Preferred Share Fund returned -0.6% for the month while the Laddered Preferred Share Index returned -0.5%. We continue to be constructive on preferred shares as RBC issued another LRCN note (Limited Recourse Capital Note) and Canadian Western Bank sold their first LRCN note. We anticipate continued redemption of outstanding bank preferred shares in banks and for insurance companies to follow suit later this year or in Q1 next year. During the month we engaged with the Sandpiper Group, a Vancouver-based private equity firm focused on investing in real estate. Sandpiper has a strong track record of realizing value in REITS and has identified opportunities for Artis REIT to realize significant value creation. We will continue to work with Sandpiper in the coming quarters as we believe these changes will help unlock value in Artis’s preferred shares.

The S&P/TSX was -3.1% while the Nicola Canadian Equity Income Fund was -2.6%. Weak performance in Information Technology and Energy was the largest negative contributor to Index returns in October. Strong performance for our Nicola Canadian Equity Income Fund in Information Technology and Industrials led to the outperformance of the Nicola Canadian Equity Income Fund for the month. The top positive contributors to the performance of the Nicola Canadian Equity Income Fund were Cargojet, Methanex, and Northland Power. The largest detractors were Maple Leaf Foods, Canwel Building Materials and Allied Properties REIT. We added a new position in wood-based panelboard producer Norbord in October. We sold Interfor.

The S&P/TSX was down -3.1% while the Nicola Canadian Tactical High Income Fund was down -2.5% for October. The Nicola Canadain Tactical High Income Fund benefited from strong performance in Information Technology and Materials offset partially by performance in Financials and Communications Services. The Nicola Canadain Tactical High-Income Fund has a Delta-adjusted equity exposure of 89% and the projected cash flow yield on the portfolio is 8%. In the month, we sold our position in Guardian Capital while we added to our exposure in the Materials sector by adding Norbord Inc.

The Nicola U.S. Equity Income Fund matched the -2.7% for the S&P 500. The Nicola U.S. Equity Income Fund’s returns were mixed by outperforming in certain sectors such as Financials, Consumer Staples, Utilities and Information Technology while underperforming in Communication services, Energy and Industrials relative to the benchmark. During the month, we sold some two names (Proctor & Gamble, Boeing and M&T Bank) and redeployed into four new names (Activision Blizzard, Qualcomm, Texas Instruments and Morgan Stanley). We also wrote 10 covered calls to take advantage of heightened volatility pre-U.S. election. The Nicola U.S. Equity Income Fund ended the month 13% covered. The Nicola U.S. Equity Income Fund has a delta-adjusted equity exposure is 97% and the current annualized cash flow is 4.3%.

The Nicola U.S. Tactical High Income Fund returned -1.0% vs -2.7% for the S&P 500. The Nicola U.S. Tactical High Income Fund outperformed the benchmark due to being underweight Info Tech and Healthcare and benefiting select names in the Consumer Discretionary sector (Cheesecake Factory, Starbucks, Aptiv and Gentex). The Nicola U.S. Tactical High Income Fund was active in options trading activity as implied volatility was elevated near the end of October (pre-U.S. election); we wrote 26 Put options ($39MM notional amount) and 12 Call options. Option writing continues to provide double-digit annualized premium yields with attractive upside/downside break-evens. The Nicola U.S. Tactical High Income Fund ended the month having 59% of long positions covered and delta-adjusted equity exposure of 49%. New names added to the portfolio include Morgan Stanley & Nextera Energy; names sold were Boeing and Carlisle.

The Nicola Global Equity Fund returned -1.9% vs -2.2% for the MSCI ACWI Index (all in CDN$). The Nicola Global Equity Fund slightly outperformed the benchmark due to our relative underweight in Information Technology, one of the worst-performing sectors during the month, and our regional overweight to Asia Emerging markets which was the strongest region in October. The performance was marginally offset by country/region mix (overweight Europe Developed markets which was a performance drag) and our underweights in Communication Services and Utilities sectors which were top performers during the month. Performance of our managers for the month: JP Morgan Global Emerging Markets +4.1%, BMO Asian Growth & Income +1.3%, Lazard -0.3%, C Worldwide -1.6%, EdgePoint -2.0%, Nicola Wealth EAFE -4.5%, and ValueInvest -5.3%.

The Nicola Global Real Estate Fund return was +0.5% in October vs. the iShares S&P/TSX Capped REIT Index (XRE) -2.4%. YTD, the publicly-traded REITs have lagged the broader Canadian market by a wide margin as the iShares S&P/TSX Capped REIT Index is down -22% as of the end of October. Longer-term, we are bullish on the real estate complex and we view that the distributions paid by REITs are safe and represent a large yield pick-up vs. government bonds. We also believe that the sector trades cheaply compared to what the underlying property portfolios are worth. However, volatility for the REITs likely remain elevated in the near term as investors weigh the possibility and potential impact of a second wave of the virus. Overall, we continue to favour the Industrial and Multi-family sectors and are overweight in those areas in the portfolio. There were no new names added or subtracted in October.

The Nicola Sustainable Innovation Fund returned +5.2% (USD)/ +5.2% (CAD) in October and has returned +29.8% (USD)/ +33.1% (CAD) year-to-date. BYD Co., Xebec Adsorption, and Ormat Technologies were the top contributors to performance while Sunrun, Alstom, and Iberdrola were among the detractors. Sunrun shares fell dramatically during the month after a pair of equity offerings were announced; however, we had scaled back our position and taken profits in September so the impact on overall fund performance was lessened. No new names were added to the portfolio in October. During the month we also topped up positions in Plug Power, Vestas Wind Systems, and Pinnacle Renewable Energy, among others. With how politicized the renewable energy and clean technology sectors have become in the United States, heading into the November 3rd Election we tactically had allowed our cash position to drift up to just over 12% given the potential for a Republican surprise victory or contested outcome of a Democratic win. Given what we’ve seen over the last few days following the Election this appears to have been prudent and we will continue to look for opportunities to deploy this cash as the outcome becomes clearer.

The Nicola Alternative Strategies Fund returned 0.6% in October. Currency had a negligible contribution during the month. In local currency terms since the funds were last priced, Winton returned -1.3%, Millennium 1.4%, Renaissance Institutional Diversified Global Equities Fund -3.7%, Bridgewater Pure Alpha Major Markets +0.8%, Verition International Multi-Strategy Fund Ltd 0.8%, RPIA Debt Opportunities -0.3%, and Polar Multi-Strategy Fund +2.0%. The multi-strategy funds continue to drive returns higher with strong months from Polar and Millennium. In multi-strategy funds, exposure to SPAC’s (special purpose acquisition company) remains attractive. SPACS is effectively a shell corporation that is formed to raise capital through an IPO with the goal of acquiring a private company. Our strategies take advantage of the complexities in the transition from SPAC to a new public company and have benefited from the heightened interest from investors in the space.

The Nicola Precious Metals Fund returned -1.9% for the month while underlying gold stocks in the S&P/TSX Composite index returned -4.2% and gold bullion was down -0.4% in Canadian dollar terms. Overall, gold continued its pullback during the month however select positions in small-cap names such as Calibre Mining and Belo Sun Mining helped mitigate some of the overall weakness in the space.

 

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 https://realestate.nicolawealth.com. All values sourced through Bloomberg. Effective January 1, 2019, all funds branded NWM was changed to the fund family name Nicola. Effective January 1, 2019, the Nicola Global Real Estate Fund adopted a new mandate and changed its name from NWM Real Estate Fund.