Market Commentary: The Everything Rally


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were +1.4% in the month of November.  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 +0.4% in November and is +5.7% year-to-date. Returns for the month were driven by strong contributions from Marret Investment Grade Hedge Strategies Fund and Arrow East Coast Investment Grade Fund returning 0.8% and 1% respectively. Returns from both Marret and Arrow East Coast were driven by credit selection and active trading as general credit spreads remain relatively tight. New issuance this year surpassed last year’s pace with close to $100B issued year to date. Issuance during November was dominated by BBB’s, which represented 83% of primary transactions. We continue to maintain an overweight in BBB names as credit quality in BBB’s remain attractive in Canada versus their global peer group.

The Nicola High Yield Bond Fund returned +1.1% in November, and is +5.9% year-to-date. Currency provided a boost of 0.5% to the fund as a stronger U.S. dollar contributed positively to returns. Credit fundamentals in high yield remain stable. High yield issuance for the year remains strong but a significant portion of new issues were used to finance and extend current debt further out causing the picture of net supply to not dramatically change.

Next year, there will likely be new money entering the market and the supply demand dynamics in the market may not be as attractive. Trends seen throughout the year continue to remain on track. Low quality CCC’s continue to mark new lows in the market, widening the valuation gap with BB companies.  However, BB spreads in the U.S. may come under pressure as companies in this space focus on shareholder returns through M&A opportunities causing a re-leveraging.

The Nicola Global Bond Fund was down -0.1% for the month. Brazil and Argentina sold off during the month leading to weakness in the Templeton Global Bond fund as it returned -0.4%. The softness in the Templeton Global Bond fund was partially offset by gains in the Pimco Monthly income fund which rose 0.3% for the month.

Government bond yields rose across most of the developed world in November. In the U.S., U.S. Federal Reserve Chair Jay Powell noted the generally good health of the economy and indicated that the Fed would likely hold rates ready for the time being. Higher interest rates were a headwind for Pimco Monthly Income but losses from interest rates were more than offset by tightening credit spreads and exposure to non-benchmark names which helped guid Pimco Monthly Income to positive returns for the month.

The Nicola Wealth 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 4.1% for the Nicola Primary Mortgage Fund and 5.3% for the Nicola Balanced Mortgage Fund.  The Nicola Primary Mortgage Fund had 16.4% cash at month end, while the Nicola Balanced Mortgage Fund had 20.8%.

The Nicola Preferred Share Fund returned +1.6% for the month while the BMO Laddered Preferred Share Index ETF returned +1.1%.  Preferred shares moved higher as both 5 year Government of Canada bond yields moved higher and sentiment improved in the preferred share space with strong positive flows into ETF’s. However, demand specifically for floaters (floating rate issues) appears to have waned. Both Enbridge and Pembina extended rate reset issues during the month giving holders the ability to convert to a floating series but not enough holders voted in favor of conversion to floating to reach the minimal threshold so all issues will remain fixed to the 5 year Government of Canada yields.

The S&P/TSX was up +3.6% while the Nicola Canadian Equity Income Fund was +4.0%. The Financials sector was the largest positive contributor to the Index for November followed by Energy. Health Care was the largest negative contributor. The outperformance of the fund was mainly due to being overweight the Industrials and Consumer Discretionary sectors. Leadership in the market seemed to transition toward cyclical sector and value equities. Consequently on an individual stock basis, the top positive contributors to the performance of the fund were smaller value oriented names: Canwel Building Materials, Diversified Royalty Corp, and Pinnacle Renewable Energy. The largest detractors to performance were Rogers Sugar, NFI Group, and Wheaton Precious Metals. There were no new additions or deletions to the portfolio.

The Nicola Canadian Tactical High Income Fund returned +2.1% vs the S&P/TSX’s +3.6%.  The Nicola Canadian Tactical High Income Fund benefited from being overweight in Consumer Discretionary names; however, the underweights in Financials, Info Tech and Energy detracted from relative performance.

Option volatility increased 13% during the month.  The Nicola Canadian Tactical High Income Fund was able to find opportunities to earn high single-digit Put option premiums with double-digit downside protection on select names. The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 57% (65.9% prior) and remains defensively positioned with companies that generate high free-cash-flow and generally have lower leverage relative to the market.  Enbridge is a new name to the portfolio.

The U.S. Equity Income Fund returned +2.6% (USD), while the S&P500 returned +3.6%.  Our exposure to defensive sectors such as Utilities and Consumer Staples hurt relative performance.  In terms of stock selection, stable businesses such as cell-tower operator Crown Castle, utility Nextera Energy, and beverage company Pepsico, were down for the month which more than offset gains in growth stocks Adobe and Accenture, as well as UnitedHealth.  We sold Carnival after pricing wasn’t as strong as expected, and bought WalMart on expectations of margin improvement in their U.S. ecommerce business.

The Nicola U.S. Tactical High Income Fund returned +1.5% vs +3.6% for S&P 500. The Nicola U.S. Tactical High Income Fund’s relative underperformance was due to being underweight Info Tech, Financials, Communication Services & Healthcare.  Stock selection was positive within Consumer Discretionary and Industrial names but was offset by stock selection within Financials and Consumer Staples.

Option volatility decreased 4.5% during the month with the largest amount of volatility occurring at month-end.  The Nicola U.S. Tactical High Income Fund has been very selective in deploying capital.  We were still able to generate double-digit annualized premiums with high single-digit break-evens.  The combination of the rally in stocks and the option-overwriting decreased the delta-adjusted equity from 40.2% to 34%. No new names were added.

The Nicola Global Equity Fund returned +2.4% vs +3.3% for the iShares MSCI ACWI ETF (all in CAD).  As the U.S. led global equity markets, our pool’s weight in international hurt our relative performance.  The IT sector, which the fund has a relative underweight in, was the strongest performing sector last month; while defensive sectors such as Consumer Staples, where we are overweight, lagged.  Our Global Small Cap and Growth managers outperformed our International-focused strategies with performance of our managers in descending order: Lazard Small Cap: +3.1%, CWorldwide +3.0%, Global Value +2.7%, Edgepoint Global: +2.5%, Nicola EAFE: +2.5%, BMO Asian Growth & Income +1.4%.

The Nicola Global Real Estate Fund return was +1.5% in November vs. the iShares (XRE) +1.7%. Publicly traded REITs continued their strong performance as the interest rate environment is positive for real estate. With the exception of mid-market enclosed retail and Calgary office, real estate operating conditions appear favourable across most major asset classes in most major markets (high occupancy and rising rents) and there is upward pressure on replacement costs (land; labour; hard costs; development charges).

Current valuation levels are fair but further multiple expansions may be difficult to achieve. We think the best opportunity to be in the multi-family and industrial sectors where the multi-year outlook appears strong for rental growth. There were no new additions or deletions to the portfolio in November.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of November 30th, October 31st  performance for the Nicola Canadian Real Estate LP was +0.3%, the Nicola U.S. Real Estate LP +1.2%, and the Nicola Value Add LP +1.0%.

The Nicola Alternative Strategy Fund returned 0.5% in November (these are estimates and can’t be confirmed until later in the month).  Currency contributed 0.6% to returns as the Canadian dollar weakened through the month. At the end of the month we revised our pricing policy for the fund to align better with existing Nicola Wealth funds. Previously the Nicola Alternative Strategy Fund was priced 18 business days after month end; we have revised the Nicola Alternative Strategy Fund so that it is priced two days after month end. To assist in the management of liquidity for the Nicola Alternative Strategy Fund we have introduced a three month notice period for redemptions. Because of the change in policy, returns for the month of November only reflect the last week of the month. During this period only three managers reported changes in their values in local currency terms, Winton returned -0.3%, Renaissance Institutional Diversified Global Equities Fund 0.0%, and Polar Multi-Strategy Fund -0.1%.

The Nicola Precious Metals Fund returned -0.4% for the month while underlying gold stocks in the S&P/TSX Composite index returned -1.9% and gold bullion was down -2.4% in Canadian dollar terms. Generally gold stocks are more levered to bullion prices so it is somewhat of an anomaly to have bullion sell off more than stocks. Outperformance from the RBC Global Precious Metals Fund was driven by stock selection as Wesdome Gold mines continued its strong showing from last month returning +8.5% along with strong contributions from Detour Gold and K92 Mining.

 

November in Review

The Everything Rally remained firmly in place last month as most asset classes maintained or even added to year to date gains last month.  With only one month to go in 2019, a balanced portfolio comprised of 60% stocks and 40% bonds is on course for its highest returns since 2009.

It’s not unprecedented for bonds and stocks returns to be positively correlated, but lower rates and strong bond returns are usually attributed to slower economic growth and lower equity returns.  Lately, it hasn’t mattered what yields have done, stocks have been moving higher.  Last month, bond yields moved up and the S&P 500 had the best November in a decade, while the Dow reached and exceed 28,000 for the first time ever.

The gains weren’t confined to U.S. stocks either, with the exception of Chinese equities, most global bourses ended the month firmly in the black.  In Canada, the S&P/TSX gained nearly 3.6%, within a rounded error of the S&P 500’s gain.  Of course stocks were moving along nicely at this point last year as well, before falling over 9% in December.  Macro Research shop Strategas assures us a repeat this year is unlikely, given back to back negative December’s has only occurred four times since 1950.   We will hold them to it!

Working in Strategas’ favor have been strong market technicals in November, with 75% of stocks in the S&P 500 trading above their 200 day moving average (versus only 50% last year) led by smaller capitalization stocks and cyclical sectors like banks and industrials.  These are all typically signs of a stronger economy, as are higher bond yields.

After consistently falling below forecasted levels, U.S. 10 year yields appear to have seen their lows in early September and continued to move higher in December, as did yields for most developed country government debt.  There is still over $12 trillion in global debt trading at negative yields, but this is down considerably from over $17 trillion in August.

Only in corporate credit do we start to see some cracks starting to form in the Everything Rally.  While investment grade and even most non-investment grade bonds continued to perform very well, the lowest grade of non-investment grade (CCC rated) have not kept pace.  This is notable because if the global economy were truly reflating, returns for CCC rated bond would be expected to outperform.  The fact they are not implies concerns over the credit cycle, and likely the economy in general.

 

The current rally is one of the most mistrusted and unloved in history

High Yield bond performance is but one example of the current rally being one of the most mistrusted and unloved in history.  Despite year to date stock returns of over 25% (S&P 500 +27.6% total return in local currency at the end of November), data provider Refinitiv Lipper recently reported investors have withdrawn over $135 billion from U.S. Stock funds and ETF’s this year, the most on record (or at least the most since 1992 when they started recording the data).

While this can be a bullish indicator as it means there is plenty of potential upside if or when investors start to flock back to stocks, it isn’t exactly a vote of confidence in the Everything Rally and its ability to continue into the New Year.

 

Strategists are split in their outlook on both stocks and bonds.  

For bonds, some see the Fed continuing to ease in 2020, driving 10 year yields lower and following the path of European and Japanese rates.  For others, the three rates cuts were just what the rally ordered, drawing comfort from the favorable market experience after the mid-cycle rate cuts of 1995.

In this favorable economic scenario, there is room for 10 years to drift higher.  For stocks, Morgan Stanley and UBS have been the most vocal in claiming lower corporate earnings will push market returns lower in 2020, while the bulls at BMO believe the current 10 year rally in only reaching its half way point, with plenty more upside to come.

Who is right, and what factors will determine the direction of the market in 2020?  Likely the same forces investors were focused on last month, namely the US/China trade war, the Fed and monetary policy, the economy, and finally, the 2020 US election.  Next month we will go into more detail on how these four factors will impact markets in 2020.  In this month’s comment we’ll try and focus on their impact this year, and November in particular.

 

Will he or won’t “Xi” agree to a deal?

Probably the biggest source of volatility for the market this year has been the trade war between the US and China.  When negotiations appear to hit a wall, the market declines.  When it looks like progress is being made, stocks rally.

Investors are left powerless as the two economic superpowers engage in a high stakes negotiating battle, trying to determine “will he or won’t Xi” agree to a deal.  The concerns are valid.  The U.S. has applied tariffs on about $360 billion of Chinese imports, but alternative foreign sources have meant the disruption to U.S. companies and consumers has been manageable.

Additional tariffs scheduled to start December 15th will be on Chinese imports, and are harder to replace.  It is likely either U.S. corporate profit margins or U.S. consumer pocket books will bear most of the pain.  Both sides are working towards some kind of phase one agreement that will see no new tariffs in December and probably some kind of roll back in existing tariffs.

For its part, China will agree to buy more agriculture, especially desperately needed pork. The African swine flu has wiped out about half of China’s pork production, an important stable on Chinese dinner tables, resulting in a disturbing spike in food inflation.  Chinese CPI in November rose 4.5% year over year, its highest since January 2012.

 

Trump wants and needs a deal

According to the Donald, China wants a deal now, but he is content to wait until after the U.S. election next year.  Don’t believe it.  Posturing aside, Trump wants and needs a deal.  The only one that appears to not want a deal is Congress.  Two bills addressing human rights transgressions in China attained bipartisan support and passed through the Republican controlled Senate by unanimous consent, meaning not a single Senator stood in its way, preventing President Trump from using his veto, even if he wanted to.

This is notable because it certainly doesn’t help U.S. negotiators in reaching a deal with China, and it is rare that the Republican Senate would work against its own administration. Most still believe a Phase one deal will be made, but it’s taking longer than initially thought.  Optimism over a deal helped the market in November, but Traders are nervous knowing either side will walk away rather than sign what they consider to be a bad deal.

 

An accommodative Federal Reserve

Balancing off any disappointment on the trade front has been an accommodative Federal Reserve.  After cutting three times in 2019, the Fed looks to be done cutting rates for now, but remains on call to lower rates again if necessary, like if the trade war ramps up.

More importantly, however, Chairman Powell has indicated the U.S. central banks won’t raise rates until inflation has moved significantly and persistently higher, meaning the Fed could be on the side lines for an extended period.  In addition, the Fed has started buying about $60 billion Treasury Bills a month in order to add liquidity to the overnight repo market (repurchase agreement market), which Banks use to fund their trading books.

Interest rates in the repo market spiked higher at the end of September (Banks needed to draw down reserves in order to make quarterly tax payments), indicating excess Bank reserves at the Fed weren’t large enough.  The Fed draws a distinction between these new purchases and the quantitative easing programs used to fight the financial crisis, but the impact on liquidity and financial markets should still be positive.  According to Citigroup, total global central bank asset purchases should hit $1 trillion by September 2020.

 

Monetary policy will be needed to keep investors from focusing on corporate earnings, which are expected to remain modest at best. 

According to Morgan Stanley, more than a third of S&P 500 companies reported lower earnings in 2019 and Societe Generale believes lower profit margins will mean earnings will continue heading lower.  This could be problematic given stock prices already appear to have decoupled from profits.  It’s not a given earnings will weaken next year, however.  Some of the weakness in earnings this year can be attributed to tough 2018 comparables, with 2018 earnings benefiting from the 2017 tax cuts.

SocGen believes wage growth and higher labor costs will be the main reason profit margins will come under pressure next year.  Higher wages are good for consumer spending, however, which would be good for the economy and corporate top lines.

 

 

So far, economic growth for 2020 looks resilient.

The economy will likely be the final arbiter for the direction in corporate earnings next year, and so far economic growth looks resilient.  Manufacturing continues to look weak with non-residential fixed investment contracting in the second half of 2019, but manufacturing isn’t the force it once was for the U.S. economy, and slower growth doesn’t mean negative growth.  Most forecasters have 2020 GDP growth coming in just under 2% growth next year, not far off trend growth since the great recession.  Less than 35% of economists in a recent WSJ survey believe a recession will begin next year.

 

The consumer is just too strong for a recession to feel immanent. 

Job growth last month was a robust 266,000 with the unemployment rate moving down to 3.5%, lowest since 1969.  To SocGen’s point, wage growth was higher than expected at 3.1%, but hardly strong enough to cause concern at the Fed.  Holiday retail spending is forecast to be strong, and lower mortgage rates have helped boost new home sales.

Even global growth looks to be stabilizing.  Sure, growth is expected to be modest, but slow growth is still growth, and it means monetary policy is likely to remain accommodative.  After all, the current bull market, the longest in history, has been built on modest growth.

 

 

What could derail this happy environment for investors? 

Well the 2020 Presidential election comes immediately to mind.  We still believe the impeachment trials are a non-issue.  Trump’s popularity has barely moved.  Democrats still hate him, and most Republicans still see him as a necessary evil.

Unless Trump’s support deteriorates materially, the Senate will not vote to impeach President Trump.  In the meantime, the Trump playbook has been to look as presidentially busy as possible, which is why leaked video footage of Canadian Prime Minister Trudeau appearing to mock the U.S. President at the recent NATO summit was so unfortunate.

He’s trying people, cut him some slack!  In reality, this is an unforced error by our Prime Minister.  Making the leader of the free world and our largest trading partner look bad can’t be good for Canada, particularly if that leader is a narcissistic egomaniac.

Like it or not, a Trump victory in 2020 is good for the markets, and we didn’t see anything last month that would indicate his chances of being re-elected have materially declined.  PredictIt still shows Trump’s odds of winning holding steady, while it remains very unclear which Democrat he will face come November.  The market’s biggest fear is an Elizabeth Warren victory, who was the front runner only a month ago.  Fortunately, Warren’s Medicare for All policy has hurt her popularity and the Massachusetts Senator’s support has since crumbled.  We are not saying this is why the market rallied in November, but it didn’t hurt.

 

Strength of the market last month and year to date has been stronger than expected

While we’ll take the returns, we admit the strength of the market last month, and year to date, has been stronger than we expected.  Low interest rates and an accommodative central bank are likely the main drivers behind this good fortune, in combination with growth strong enough to avoid recession, but weak enough to keep inflation at bay.  The problem with modest growth, however, is it is more susceptible to negative shocks, both economic and geopolitical.  The trade war with China and the 2020 Presidential election top the list of potential spoilers, and while both weren’t major factors for the markets last month, 2020 might not be so lucky.  But more about 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.