Market Commentary: Enjoy the Party This Year, Because There will be a Hangover


By Rob Edel, CFA

Highlights This Month

Read the pdf version

 

Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were +0.2% in the month of December, and an even 10.0% for 2019.  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 December and is +6.1% year-to-date (as of Dec. 31, 2019).  Recently we used proceeds from the redemption of the Sunlife Private Fixed Income Plus Fund and redistributed into short term bonds with the goal of marginally improving credit risk, while improving liquidity and reducing interest rate duration exposure.

Returns in December for the general fixed income market (iShares Core Canadian Universe Bond Index ETF) saw losses of -1.1%. The headwind from rising interest rates was largely muted for the Nicola Bond Fund as we are overall positioned with low duration. Credit spreads continue to be driven by technicals as foreign buying and demand for yield has driven credit spreads lower as opposed to credit fundamentals.  As a result, we believe it is prudent to focus on defense and generate excess returns through active trading.

The Nicola High Yield Bond Fund returned -0.5% in December and is +5.4% year-to-date (as of Dec. 31, 2019).  Currency was a significant headwind for the month with a -1.1% detraction to fund returns as the U.S. dollar weakened.  Credit spreads tightened through the year, helping to drive returns, but are still wider than 2018 levels.  However, the overall picture is slightly deceiving given the significant bifurcation in the high yield market.  High quality BB names finished the year with record low yields while CCC names closed the year with yields above 10%.  Similarly, default rates for the year came in at a very normal 2.1%.  Surprisingly, the retail industry which had been under pressure in 2018 rebounded strongly for 2019, whereas defaults effectively all came from energy names which represent roughly 15% of the market.

The Nicola Global Bond Fund returned +0.7% for the month.  The Nicola Global Bond Fund’s exposure to risk assets in both developed and emerging market credits contributed to performance as credit spreads tightened around the world.

Currency positioning in Latin America (Brazilian Real and Columbian Peso), Asia ex-Japan and positions in Northern Europe helped performance, but was partially offset by weakness in Templeton’s USD$ exposure.  Performance of our managers in descending order: PIMCO Monthly Income +1.1% and Templeton Global Bond +0.8% and Manulife Strategic Income Fund -0.2%.

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 +0.5% respectively last month.  Current yields, which are what the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage 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 4.2% for the Nicola Primary Mortgage Fund and 5.4% for the Nicola Balanced Mortgage Fund.  The Nicola Primary Mortgage Fund had 11.7% cash at month end, while the Nicola Balanced Mortgage Fund had 15.7%.

The Nicola Preferred Share Fund returned +3.5% for the month while the BMO Laddered Preferred Share Index ETF returned 2.7%.  Government of Canada 5 year bond yields moved higher by 0.20% to end the year at 1.69%.  During December, Pembina Pipelines closed their acquisition of Kinder Morgan (KML) with the preferred shares changing tickers from KML to PPL.  Maintaining a history of dividend increases, Enbridge announced during their investor day a planned 9.8% increase in dividends in-line with their 10% growth guidance for the common equity stock.  Common stock dividend increases support preferred shares indirectly as stock dividends need to be cut to zero before preferred share dividends can be reduced.  National Bank and Royal Bank both tapped credit markets for bail-in and non-viability contingent capital (NVCC) debt.  Given maturities don’t start until June 2020, there will likely be muted new issues for NVCC during the earlier part of the year.

The S&P/TSX was up +0.4% while the Nicola Canadian Equity Income Fund was unchanged.  The Energy sector was the largest positive contributor to the Index for December followed by Materials as Gold producers finished the year strongly.  Financials was the largest negative contributor.  The underperformance of the Nicola Canadian Equity Income Fund was mainly due to being underweight Gold and Information Technology.  The top positive contributors to the performance of the Nicola Canadian Equity Income Fund were smaller value oriented names: Pinnacle Renewable Energy, Maple Leaf Foods, and ATS Automation Tooling Systems.  The largest detractors to performance were Interfor, CP Railway, and Shaw Communications.  In December, we added two new positions: Restaurant Brands International and CP Railway.  We sold Brookfield Property Partners.

The Nicola Canadian Tactical High Income Fund returned +2.1% vs the S&P/TSX’s +0.5%.  The Nicola Canadian Tactical High Income Fund benefited from being underweight financials and overweight Materials and Communication Services.  The largest stock contributor during the month was Cineplex Inc.; mid-December Cineworld proposed buying Cineplex for just over $2.1B which resulted in the stock climbing +33.9% during the month.  Option volatility increased 10% during the month (flat last two weeks of December).  The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 66.5% (57% prior to last month) and remains defensively positioned with companies that generate high free-cash-flow and generally have lower leverage relative to the market.

The Nicola U.S. Equity Income Fund returned 2.5% during the month, trailing the S&P500 which returned 3.0%.  Positive relative performance from positions in EOG Resources, Crown Castle, and NVidia, were more than offset by declines in Boeing and Costco, as well as our underweight in Apple.  We exited AIG and bought Citigroup; and sold Home Depot to buy Lowe’s.

The Nicola U.S. Tactical High Income Fund returned +0.4% vs +3.0% for S&P 500.  The Nicola U.S. Tactical High Income Fund’s relative underperformance was due to being underweight in Info Tech & Healthcare.  Stock selection was mixed: negative within Consumer Discretionary and positive selection within Consumer Staples and communication services (Electronic Arts was +6.4%).

Option volatility decreased 7.7% during the month.  The Nicola U.S. Tactical High Income Fund was very selective in deploying capital (excess cash of 18% at month-end).  The delta-adjusted equity rose slightly from 34% to 37%.  New names: Aptiv – Tier 1 Automotive supplier that is well positioned for the secular long-term electrification theme.

The Nicola Global Equity Fund returned +0.3% vs +1.1% for the iShares MSCI ACWI ETF (all in CDN$).  The Nicola Global Equity Fund underperformed the benchmark due to country/region mix (underweight Latin America and overweight Japan) and sector selection (underweight Info Tech, Financials and Energy while being overweight in Consumer Staples).  Market-cap and style had a neutral impact as the Nicola Global Equity Fund’s lower relative market cap was offset by its overall growth style tilt.  Performance of our managers in descending order was BMO Asian Growth & Income +1.6%, NWM EAFE Quant +1.3%, C Worldwide +1%, ValueInvest +0.3%, Lazard -0.1% and Edgepoint -1.2%

The Nicola Global Real Estate Fund return was -1.8% in November vs. the iShares (XRE) -2.2%.  Publicly traded REITs had a strong year in 2019 but in December, the Canadian REITs cooled.  The fund was also hit by foreign exchange as the USD was off -2.2% in December.  The low interest rate environment is a positive for real estate and property level fundamentals are improving.  Absent a material change in the current environment, we think that the set up for 2020 is a good one for the REITs.  We continue to think that the best opportunity to be in the multi-family and industrial sectors where the multi-year outlook appears strong for rental growth.  Globally, based on differences in the market-level total return outlook, we intend to increase our weight to Asia Pacific.  There were no new additions or deletions to the portfolio in December.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of December 31st, November 30th performance for the Nicola Canadian Real Estate LP was +0.6%, Nicola U.S. Real Estate LP +0.6%, and Nicola Value Add LP +1.0%.

The Nicola Alternative Strategies Fund returned -1.0% in December (these are estimates and can’t be confirmed until later in the month).  Currency detracted -1.5% to returns as the Canadian dollar strengthened significantly through the month.  In local currency terms, Winton returned -1.5%, Millennium +0.2%, Renaissance Institutional Diversified Global Equities Fund -2.6%, Bridgewater Pure Alpha Major Markets +3.0%, Verition International Multi-Strategy Fund Ltd +1.1%, RPIA Debt Opportunities +0.6%, and Polar Multi-Strategy Fund +2.1% for the month.  Winton’s returns were impacted by metal positions which detracted from returns.  In August, nickel prices soared after the Indonesian government announced a 2020 export ban but since then the market has sharply reversed course.

The Nicola Precious Metals Fund returned 6.3% for the month while underlying gold stocks in the S&P/TSX Composite index returned 5.2% and gold bullion was up 1.4% in Canadian dollar terms.  Apart from Barrick Gold which had a stellar month up +8.8%, large cap gold companies underperformed their mid and small cap counterparts.  Currently, we believe there is more opportunity in the mid cap space where management is better aligned with shareholders and any improvement in reserve life or asset quality has a larger impact on the stock price.  RBC Global Precious Metals Fund continues to benefit from mid-cap companies such as Wesdome Gold mines and SSR Mining.

 

December in Review

Positive returns in December capped off a record year for risk assets with nearly every asset class advancing.  Stocks did particularly well, with the S&P 500 up over 31% (in US dollar terms) and the S&P/TSX nearly 23% higher, but bonds, commodities and real estate also rewarded investors with good returns.

In a lot of ways 2019 was the mirror imagine of 2018, which nearly ended the year with stocks in a bear market.  In fact, negative returns in the fourth quarter of 2018 and their subsequent recovery in 2019 was one of the reasons 2019 was such a good year.  Rather than just looking at the 2019 calendar year, if returns were measured starting from the end of September 2018, results are not as impressive.

Taking 2018 and 2019 together, the S&P 500 provided a respectable annualized +12.1% return versus +5.8% for the S&P/TSX.  Measured over the past decade, from 2010 to 2020, the S&P 500 has annualized +13.5% and the S&P/TSX +6.9%.  It’s been a wild ride, but the bull market of the 2010’s was one for the record books.

 

But what about 2020 and the next decade? 

According to RBC Capital Markets December Investor Survey, over 50% of institutional investors have a bullish outlook for U.S. stocks over the next six to twelve months versus only 15% who are bearish (34% are neutral).  Now being “bullish” can be a fairly broad statement.  Not many (meaning none) predicted a 31% return for U.S. stocks last year, and we don’t think too many believe returns will be anywhere near this high in 2020.  It is also unlikely all asset classes will end the year in the black.  The “everything” rally we got last year will be tough to duplicate.  Mid-single digit returns would appear to be the safe bet, driven by the same four factors that drove returns in 2019.

As we highlighted last month, the US/China trade war, the 2020 U.S. election, the global economy, and central bank monetary  policy, all played a role in influencing capital markets last year, and will again this year.  Let us discuss each in more detail.

 

The biggest contributor to market volatility last year was the U.S./China trade war.

When negotiations appeared to be going well and a breakthrough was immanent, risk assets rallied.  When these negotiations fell apart, markets sold off.  Signs a truce of some sort had been reached started to materialize in October, with an apparent “Phase one” deal agreed to in early December.

Details are limited given a written agreement has not been released, but the meat of the deal involves the U.S. cutting or deferring tariffs in exchange for an increase in Chinese purchases of U.S. exports.  According to the U.S., China has agreed to increase its purchases of U.S. goods and services by $200 billion, and $40 to $50 billion in U.S. agricultural products over the next two years.

While U.S. negotiators believe these numbers are realistic, a breakdown of specific targets will be classified.  China has also agreed to end the practice of forced intellectual property transfer and a dispute-resolution mechanism has been settled on.  Phase two negotiations, which will tackle more contentious issues like Chinese subsidies to state-owned enterprises, are expected to start immediately.  The good news for markets is the phase one deal prevents a further escalation in the short term.

 

China is battling a slowing economy, and President Trump is facing an upcoming election.

This doesn’t mean the trade war still isn’t a risk for the markets in 2020.  There are still lots of ways it can fall apart.

First off, the fact China hasn’t confirmed some of the details U.S. negotiators have discussed is disturbing.  Second, China’s ability to hit targets highlighted by U.S. negotiators is debatable given the historical level of U.S. exports to China.  What if they fall short?  Another negative scenario might center on the phase two negotiations.  If China isn’t willing to make concessions, could Trump take a harder line on the interpretation and enforcement of Phase one?  If the U.S. economy surprises to the upside, does Trump take a firmer stance?

Phase one is a deal in name only.  Really it’s more of a truce.  While China might try and buy more U.S. goods, they are not going to make material changes in how their authoritative command economy operates.

China has also taken note of Japan’s experience in making concessions to the U.S., notably the Plaza Accord signed in 1985 which doubled the value of the Yen in less than three years and created asset bubbles, whose subsequent bursting resulted in economic stagnation for most of the 1990’s.  As for intellectual property theft, surely China isn’t acting any worse than the U.S. did with Britain before WWI?  For the U.S., most American politicians, both Republican and Democrat, know that the real issues extend well beyond the trade deficit the U.S. has with China.  China is viewed as an economic and military threat.  The process of decoupling the U.S. and Chinese economy has already started with China doing more business with South East Asian nations and even Europe.  One of the concerns investors had with the US/China trade war was its impact on uncertainty and capital spending.  The Phase one deal is unlikely to change this.  At best, the trade war becomes a non-issue for markets in 2020.  At worse, it falls apart and drives the market lower.

 

The 2020 U.S. election played only a minor role in market returns last year, but could be a major factor in 2020. 

The impeachment trials added some volatility, but the Republicans control of the Senate means Trump’s fate will most likely be decided in the November Presidential election, not by Congress.  Traditionally, a sitting President is very hard to beat if the economy is strong.  According to BCA Research, even after a mid-term election loss or a big scandal, a President seeking a second term has historically had a better than even chance of being re-elected.  History might not be the best guide for the future, however, given how polarized U.S. political support has become.  Support from Trump’s base has remained fairly constant, regardless of consumer confidence, as has the lack of support and approval from Democrats.

According to RBC Capital Markets, 76% of institutional investors polled in December believe President Trump will be re-elected, despite the fact a December WSJ/NBC News Poll reported only 44% of Americans gave Trump a favorable approval rating and 48% said they were certain to vote against him.

According to Predict It, a prediction market place where investors use real money to express their views, the odds of a democrat candidate winning the White House is still priced higher than that of a Republican.

Investors are probably letting their pocketbooks influence their views, as according to RBC’s Institutional Investor survey 66% believe a Trump victory would be bullish for U.S. equities versus only 4% who believed it would be bearish.  A Democrat in the White House would likely mean higher taxes, both personal and for Corporations.  Joe Biden would be the lesser of the Democratic evils, and Bernie Sanders would be the markets worst case scenario.

Volatility will likely pick up closer to the election, but if Sanders gets the Democratic nomination, markets will likely sell off.  If Biden gets the nomination, as is expected, there will be little to no impact.  The risk is that the market is discounting a Trump victory, which seems a little premature given Trump’s current popularity and polling numbers, especially when going head to head against Joe Biden.  Regardless, it should be great theatre, no matter who wins the democratic nomination and goes against Trump.  Political ad-tracking company Advertising Analytics estimates the 2020 political ad spending cycle could reach a record $6 billion, with nearly $1 billion being spent on the Democratic primary alone.

 

An economic slowdown would seal President Trumps’ fate.

The state of the economy will play a large role in determining who wins the White House this November.  An economic slowdown or recession would likely seal President’s Trumps’ fate as a one term President.  It would also go a long way to sealing the market’s fate.  A slowing Global economy spooked investors last year, especially after U.S. manufacturing also eventually turned lower.  The trade war and resulting uncertainty left companies paralyzed and reluctant to invest capital, a situation that will hopefully be helped by the Phase one trade deal, but likely not eliminated.

The slowdown in China’s economy was particularly concerning considering how important the world’s second largest economy has been for global growth over the past decade.  Chinese policy makers, however, have promised more monetary and fiscal measures to bolster growth, and manufacturing indices have turned higher.  As for the U.S., the consumer remains key, and even though manufacturing remains weak, the negative impact from the since settled GM strike and hopefully soon to be settled Boeing 737 Max fiasco, should stabilize the U.S. manufacturing sector.  Regardless, it’s the consumer that rules the American economy and low unemployment and strong consumer confidence means GDP growth should remain positive.  Recent strength in the housing market could also lead to an upside surprise.

 

For Canada, what is good for the U.S., is good for their northern neighbors. 

The U.S. is by far Canada’s largest trading partner, with over 70% of Canadian exports heading south across the 49th parallel.  The USMCA (old new NAFTA), which looks to be finally working its way through Congress, should ensure Canadian access to American markets for the foreseeable future.

According to BMO Capital Markets, Canada’s population grew 1.5% year over year in Q4 versus U.S. population growth of just under 0.5%, largely due to immigration.  According to Bloomberg, Canada welcomed 300,000 new immigrants and over 170,000 non-permanent residents last year, with 60% entering as part of targeted economic entry plans.

Economic growth is the addition of population growth and productivity growth, and Canada’s immigration policy helps increase both.  On the negative side, inflated housing costs and high debt levels have put Canadian consumers in a vulnerable position.  Even with low interest rates and a strong job market, consumer insolvencies have started to move higher.  It’s a good thing we have access to U.S. consumers, because Canadians need to pay off their debts so consumer spending won’t be the growth driver in Canada that it will be for the U.S. economy.  Look for the Canadian economy to continue growing at a modest pace, but below that of the U.S. economy.

 

Monetary policy remains accommodative next year

One of the reasons we have confidence economic growth should remain positive next year is monetary policy remains very accommodative, not only in Canada and the U.S., but globally.  While we started off this commentary highlighting the impact the trade war had on markets last year, the other event we believe heavily influenced returns in 2019 and created the “everything rally” was the pivot by the U.S. Federal Reserve, from a tightening policy in 2018 to an easing policy in 2019 with three cuts to overnight rates totaling 0.75%.

In 2018 when the Fed was tightening (the Fed raised rates four times in 2018) and markets sold off, the Fed appeared to be trying to catch up to the market.  The message the market was sending was that financial conditions were too tight given the current economic conditions.  Fed Chairman Powell got the message and pivoted policy from tightening to easing and the market spent most of 2019 trying to catch up.  The resulting impact can be clearly seen by the rapid increase in money supply (M2 Money Stock), which turned sharply higher last year as the Fed Funds target rate declined.

The Fed has indicated they are done cutting rates for now, though the market is hoping for one more cut in 2020 or 2021.  At the very least, investors now believe Chairman Powell stands ready to come to the market’s recue if the trade deal falls apart, Bernie Sanders becomes President, or if the economy starts to slow materially.

Like Alan Greenspan, Ben Bernanke, and Janet Yellen before him, Powell has the market’s back.  The Fed sees a long pause in monetary policy and doesn’t appear to have an appetite to raise rates anytime soon.  The key to how long they remain on hold is inflation.  The Fed wants to see inflation above 2% for an extended period of time before starting to tighten again. They are concerned that inflation has been unable to hit their 2% target and worry inflationary expectations will continue ratcheting lower and lower.

A “make up” strategy, where by inflation rates are allowed to rise above target for a period of time to compensate for the time below target means inflation could be allowed to move uncomfortably higher before the Fed take action.  Already some inflation measures are showing inflation running above 2% and inflationary expectations have also shadowed oil priced to move higher after bottoming in early October.

The Fed’s favored inflation indicator, Personal Consumption Expenditures index, was only 1.6% in November, however.  Perhaps an ominous harbinger or omen of what might transpire in the near future was the death of former Federal Reserve Chairman Paul Volker in early December.  Volker is famous for breaking the back of inflation in the mid 1980’s by aggressively and painfully tightening monetary policy.  Volker’s legacy is more than three decades of declining inflation, which might now be coming to an end.

Don’t get us wrong, an accommodative Fed is good for the economy and the stock market, over the short term at least.  The picture for fixed income is more mixed.  With the Fed on hold, the yield curve should steepen (which it has), which means longer term yields rise and bond returns become more challenging.

 

A stronger economy should positively impact credit spreads, and help offset the impact of rising interest rates for corporate bonds. 

The hope low yields in developed bond markets like Japan and Germany will place a ceiling on U.S. yields by drawing Japanese and German investors into U.S. Treasuries is likely mis-placed.  Not only have yield curves globally started to steepen, with Japanese and German 10 year yields also moving higher (the total market value of negative yielding bonds globally has fallen to nearly $11 trillion in early 2020 after topping $17 trillion in late August), but the trade doesn’t work for foreign investors buying Treasury’s if they are unwilling to take U.S. dollar currency risk.

If they wish to hedge their currency risk back into Yen and Euros, not only will their yields still be negative, but they will be more negative than if they invested in their own domestic government bonds.  Such is the current demand for U.S. dollars that the hedging costs more than wipes out the yield differential.  This is not the case for U.S. investors, however, who can turn negatively yielding Japanese and German government bond yields into positive returns by hedging their Yen and Euro risk.

Investing in a currency hedged Japanese government position can actually provide U.S. investors higher returns than investing in U.S. treasuries.  Go figure.

While a more dovish Fed might provide headwinds for fixed Income in 2020, it’s all good for equities, and one of the reasons stocks ended 2019 on a high note and has continued to rally in early 2020.

A liquidity driven rally could create a “blow-off” top or “melt-up” if the market gets too extended, however, and an inevitable correction would follow.  Over 80% of S&P 500 stocks are trading above their 200 day moving average and equity ETF’s saw increased flows in the last quarter of 2019.

Valuations also remain a concern.  While forward P/E multiples for the S&P 500 still have  a long way to go before they reach the levels reached during the late 1990’s tech bubble, they are well above the 25 year average.  According to Deutsche Bank, the S&P 500 has historically traded at lower valuations 90% of the time over the past 85 years.  Valuation is one of the reasons some strategists are advising investors to avoid putting all their eggs in one basket in 2020 and to diversify away from U.S. stocks in 2020.  A more negative view, of the U.S. dollar adds to the argument.

 

High valuations are one of the biggest obstacles investors face going into 2020. 

Easy monetary policy and low interest rates have bid up the price of most financial assets.  Perhaps there are some opportunities in emerging market equities or beaten up European bank stocks, but for more conservative investors, everything looks expensive.

Bank Credit Analysts project U.S. equities will deliver only a 4% return over the next decade after delivering over 11% since 1982.  A diversified portfolio, which would include an allocation to emerging market equities, is expected to return only 4.4% or a mere 2.4% after inflation.  At some point the U.S economy, and likely the Canadian economy as well, will stall and this record bull market will end.  We don’t think it will be next year, or even the year after, but at some point the party will end.  And then what?  With central bank lending rates already at or near zero, monetary policy is nearly out of dry powder.  Government debt levels are elevated, and while there is likely room for them to go higher, it’s likely developed world governments will use this dry powder up before the next recession.  Enjoy the party this year, because the hangover is going to be a killer.

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.