Market Commentary: If It Tastes Good, It’s Probably Bad For You


By Rob Edel, CFA

 

Highlights this Month

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September In Review 

September was a risk-off month, with most markets losing ground. After reaching an all-time high on September 2nd, the S&P 500 declined over 8% (all returns in local currency terms) before rallying near the end of the month to limit the damage to -3.8%. Interestingly, the technology-heavy NASDAQ fell an even worse 11% before recovering by month end to record down 5.1%.

NASDAQ and technology stocks, in particular, have been market leaders coming off the March 23rd lows with investors flocking to one of the few sectors still able to produce earnings growth. In order to have confidence the bull market can continue, we need to see the rally broaden and include more economically sensitive sectors, thus signalling the economic recovery is gaining traction. We take some comfort by the fact the broader market outperformed the market-leading tech names last month, we just would have preferred they would do so by proving positive returns as well.

The same could be said of Canadian stocks, which have a cyclical bias. The S&P/TSX fell nearly 5% from September 2nd to 23rd, but then rallied to end the month down only 2.1%, better than big cap tech, but still negative. Fixed Income returns were even better behaved, with credit spreads widening, but only marginally. What was perhaps most surprising last month, was risk assets didn’t sell off more given most of the news last month was bad. According to RBC Capital Markets Mood of the Market survey, institutional investors are most worried about the upcoming US Election, COVID-19 and the potential for a second (third?) wave, and the economy.

A similar survey conducted by Strategas narrowed the list of concerns to a Democratic Sweep in the upcoming US election and the second wave of COVID-19, with increased tensions with China barely getting an honourable mention. Not only did we get bad news on all of these last month, but we also got bad news on the two main forces we believe are keeping the market moving higher namely monetary and fiscal policy. In order to assess the damage to the market going forward, let’s look a little closer at all five of these issues.

The driver behind nearly everything important: the pandemic.

How can we not start our discussion with the pandemic? It is the driver behind nearly everything important right now, dominating discussions of not only the markets and the economy, but politics and elections as well. Disturbingly, the dreaded second wave looks to be materializing earlier than we would have expected in the developed world, with new cases turning higher in Europe and North America.

US new cases last month seem to have declined in populous states like California and Florida, but they now appear to be accelerating in the midwest. Overall, 34 US States last month saw their 7-day average infection rates increase over last month. Fortunately, death rates do not appear to be accelerating and understanding why is important. It is likely that increased testing means we are identifying more cases, but it doesn’t necessarily mean there are more infections. Also, a younger demographic is becoming infected and age has a dramatic impact on COVID-19 mortality. It’s the direction of infections from here that is the major concern. If new cases keep moving higher, more people will inevitably get sick and end up in the hospital. The numbers are already starting to show this. The medical community has gotten better at treating COVID-19, but there are still no cures.

A vaccine is most likely not until 2021.

While President Trump would very much like to see a vaccine approved and widely available before the November 3rd election, most forecaster’s timelines have slipped well into 2021. According to the Good Judgement Project, the odds of having enough of an FDA approved vaccine to inoculate 25 million Americans by Q1 2021 also slipped last month, though it is still the most likely outcome, and higher than 50%.

Perhaps more disturbing was Pew Research’s findings in September that only 51% of Americans would actually agree to get the vaccine even if it becomes available, down from 71% in their May survey. Not surprisingly, RBC Capital’s survey of Institutional Investors finds Q3 2021 as the time frame most believe life will return to normal, whatever that it. Perhaps more importantly, what does this mean for Halloween? Do we buy candy or not? Ok, perhaps a rhetorical question. Of course, we buy candy. What’s our downside, the kids don’t come and we eat it ourselves? Perhaps the real question is do we even answer the door?

With rising infections and no near term reprieve from a vaccine, the question becomes what will be the impact on the economy? Will businesses be able to continue re-opening, or will we need to take a step back and re-introduce some social distancing measures? We don’t see a return to full lockdown, but we are seeing some regional strengthening in social distancing rules. Hopefully, we have found a happy medium, where we know what we can and cannot do. Most businesses are able to stay open, but pre-cautions, like masks and limited indoor occupancy, will be required. More problematic will be bars, restaurants, sporting events, theatres, and anything involving a large indoor gathering. Basically, work is ok, but anything fun is out. It’s like food, if it tastes good, it’s probably not good for you.

Growth has recovered, but future gains are going to be more challenging.

And this is not going to be good for the economy. Growth has recovered quicker than expected, but future gains are going to be more challenging. Americans are becoming more upbeat about the outlook for the economy and employment, but their mood might sour once their extra unemployment benefits expire and their savings start to become depleted. Employment gains appear to stall with jobless claims plateauing at levels much higher than before the pandemic. According to Goldman Sachs, roughly 60% of remaining job losses are in high virus risk industries that will likely need a vaccine before fully recovering.

Confidence in the Federal Government was tested last month.

No problem, we have the Federal Reserve and Federal Government standing by to provide whatever it takes to get us through the pandemic intact, right? This belief is what has allowed the market to largely recover its losses, despite some pretty negative numbers coming out of the economy. While we still believe this is the case, our confidence was tested last month. On the monetary policy front, the Federal Reserve stumbled a bit last month by giving some mixed messages in terms of their outlook for the economy and the need for more stimulus. The market wanted the Fed to back up their comments regarding the need for higher inflation by announcing additional quantitative easing, and they didn’t. One can argue whether it is indeed needed, especially given how much the market has rallied (like a rocket according to some), but the traders are largely greedy and easy money and ample liquidity feeds the bull market.

More important for the economy, however, is fiscal policy, or more specifically the lack of fiscal policy. After earlier believing a fourth fiscal stimulus/aid package, also known as Cares 2.0, was virtually a done deal, it now appears the odds of getting a deal before the November 3rd election is becoming more and more remote as politics takes centre stage. The Republicans appear to have drawn a line in the sand at a package valued at $1.6 trillion (Trump actually moved to $1.8 trillion in mid-October), while the Democrats want at least $2.2 trillion. Of course, we have simplified the situation as the breakdown of how the money will actually be spent are sticking points as well.

To quote Speaker of the House Nancy Pelosi in a letter sent to House Democrats on October 9th, “differences are philosophical as well as fiscal”. But surely given the situation a compromise should be in reach given both sides know more spending is needed? It’s really a matter of when, not if, as the economy could fall off a cliff if support for individuals and companies impacted by the pandemic is not put forward. Markets can wait until after the election, but not much longer.

An uncomfortable US election ahead.

Well, that’s ok, the election is November 3rd, mere days away, right? True, that is Election Day, but not necessarily when we will know who will be President, or control Congress for that matter. With more voters expected to cast their ballots by mail, it is entirely possible we won’t be able to declare a victor on election night. In fact, according to the WSJ, a recent nationwide survey reported more than 50% of voters may vote by mail versus only 20% in 2016.

To make matters more complicated, 13 States, including Michigan, New Hampshire, Pennsylvania, and Wisconsin wait until election night before starting to count ballots received by mail. It gets worse. While a total of 50% of Americans are expected to vote by mail, most of them will be Democrats. Most Republicans are expected to follow Donald Trump’s lead and vote in person. Well not so much follow his lead as follow his direction. The Donald actually votes by mail (his official residence is in Florida). As a result, it is quite possible Republicans and President Trump could be ahead on election night, only to see their lead bleed away over the following days, with Democrats and Joe Biden eventually being declared the winner. It’s why only 14% of Institutional Investors surveyed by RBC believe we will know the election results on election night. It’s also why the Donald has refused to commit to a peaceful transfer of power after the election. It’s all very uncomfortable and not what you would expect from the World’s beacon of democracy.

The market hates complicated and confusing, but it especially hates uncertainty.

There are rules and deadlines, of course, but they are complicated and confusing. The market hates complicated and confusing, but especially hates uncertainty. Option volatility has spiked higher around the election and things could get a little rocky on and after November 3rd, but we would suggest this is just short-term noise. Rules are rules, even for Donald Trump. On January 6th, Congress counts the electoral votes and a winner is declared. Inauguration day is January 20th, when the President is sworn in, either Joe Biden or Donald Trump. What happens in between is the problem, and how long can America wait for more fiscal support?

To add to the drama, three days after mocking Vice President Biden for wearing a mask during the Presidential debate, Trump was diagnosed with COVID-19. Actually, we are not entirely sure when he was first diagnosed, but this is when it was announced. Along with Trump, and the First Lady, 34 members of the White House staff to date have tested positive, turning 1600 Pennsylvania Avenue into a COVID-19 hot spot.

Predictably, the market sold off on the news but quickly recovered over the following days as the President’s condition quickly improved. What has not improved, however, has been Trump’s polling numbers, which started to turn lower after Justice Ruth Bader Ginsburg passed away and Trump and Republican Senators plans to quickly replace her with a more conservative addition to the Supreme Court appears to have worked against his re-election aspirations. A disastrous debate performance and a trip to the hospital due to COVID-19 boosted not only Joe Biden’s chances of being elected President, but also Senate Democrats’ odds of gaining a majority.

Increased odds of a “Blue Wave” (Democrats take control of Congress and the Presidency) would normally be taken negatively by the market, but most major stock indices have remained strong. Individual sectors and stocks, however, have started to react more in line with what analysts would associate with a Democratic sweep on November 3rd.

Why is there a disconnect between the direction of the markets and discounting a Trump defeat?

The disconnect between the direction of the overall market and individual stocks in discounting a Trump defeat might be due to the fact a convincing win for the Democrats would lower the risk of a contested and messy election, which would be more damaging in the short term than anything the Democrats might do once in power.

In fairness, there are also a number of offsets a Biden led government could present. Yes, taxes might go up, but perhaps tariffs on Chinese imports would be eliminated. The fiscal stimulus would be quicker and larger, and infrastructure spending would be ramped up and new jobs created. As for the virus, well it can’t get any worse. Perhaps most importantly, we would have a President less concerned about re-election and more concerned with the well-being of America, and the World actually.

“Americans will always do the right thing after exhausting all the alternatives”.

A return to some kind of normalcy and predictability in the White House would be good for humanity, and the markets. While it is true the US dollar has been weakening and bond yields have risen modestly, we don’t pin this entirely on the prospects of a Biden victory. We think it’s just as likely stronger economic growth, in both the US as well as globally, that has helped yields move higher and weakened the dollar, which typically serves as a safe haven currency.

Will Biden win? We are always cautious when it comes to politics and try not to be too political. We recognize President Trump has done some positive things over the past four years, especially from the perspective of certain special interest groups. After all, his core group of supporters number approximately 40% of the US population. We also believe the popular media are largely biased against Trump, perhaps for good reason, but they do appear to comingle their opinion with the facts. This makes it harder to accurately evaluate and analyze the true picture. Having said this, we are fairly convinced Trump is not suited to be the leader of the most powerful country in the free world, and is quite frankly, bad for democracy. We believe Winston Churchill got it right when he was quoted as saying “Americans will always do the right thing after exhausting all the alternatives”, and in this case, the right thing is Joe Biden, for democracy, and the markets.

Nicola Wealth Portfolio – Investment Returns

Returns for the Nicola Core Portfolio Fund were +0.5% in the month of September. 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 0.3% in September. Spreads widened overall during the month for the first time since March with higher beta sectors widening more. New bonds issued during the month came with effectively zero concessions. Often new issues are priced slightly cheaper than bonds trading in the secondary market to entice investors to participate in these new issues. Despite no new issue concession, deals were often oversubscribed and met with lots of demand. Even though most sectors finished with spreads wider for the month, our more defensive positioning helped us generate positive returns for the month. During September, we initiated small positions in defensive yield to call preferred shares. In select issues, we have been able to buy safe assets with yields north of 3%.

The Nicola High Yield Bond Fund returned 1.3% in September outperforming the overall high yield market which was down -0.9%.  currency was a strong contributor to returns adding 1.3% as the US dollar strengthened relative to the Canadian dollar. The overall high yield market posted negative returns as default rates rose to 5.7%. Demand waned for high yield product as ETF’s experienced outflows coupled with historical high new issuance.

In addition to currency, our outperformance came from select credit exposure in the Apollo Credit Strategies fund and our new position in convertible bond arbitrage. The Apollo Credit Strategies fund has the ability to go with both long and short credit names, due to credit spreads being relatively tight, the fund has transitioned to being more defensive by reducing overall net exposure. Our top positive returning strategy for the month was the convertible bond arbitrage strategy we initiated at the beginning of September. We believe that there remains dislocation in the convertible bond market and the strategy will benefit from attractive carry while providing a hedge or protection if equity markets sell-off.

The Nicola Global Bond Fund was up 0.8% for the month. With a more risk-off tone, the Nicola Global Bond Fund benefitted from a flight to quality. The Nicola Global Bond Fund positioning in defensive currencies such as the Yen, USD, and Swiss Franc all gained relative to the Canadian dollar, which helped drive returns higher. Templeton Global bond and BlackRock Securitized Investors posted positive local currency returns for the month while Pimco Monthly Income was a slight drag on returns overall.

The returns for the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund were +0.3% and 0.4% respectively in September. Two loans in the Nicola Primary Mortgage Fund and two loans in the Nicola Balanced Mortgage Fund remain affected by the economic impacts of COVID-19, compared to four in each of the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund in August.

One loan in the Nicola Balanced Mortgage Fund that was in default was fully repaid in September as a result of a realization process. No loans are currently in default. The Nicola Balanced Mortgage Fund funded three new loans in September and we continue to review new loan opportunities for both the Nicola Balanced Mortgage Fund and 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 4.0% for the Nicola Primary Mortgage Fund and 5.4% for the Nicola Balanced Mortgage Fund. The Nicola Primary Mortgage Fund had 12.7% cash at month-end, while the Nicola Balanced Mortgage Fund had 17.1%.

The Nicola Preferred Share Fund returned -1.1% for the month while the Laddered Preferred Share Index returned -0.9%. Preferred shares retraced some of the gains from August. Following in the footsteps of RBC, the National Bank, Bank of Montreal, and CIBC all issued limited recourse capital notes during the month. The appetite for these types of notes remains strong which will likely mean continued issuance of notes and redemption of preferred shares. TD Bank did not issue a note but redeemed a perpetual preferred share which took the market by surprise as early redemption means they will need to pay $26 as opposed to $25. We believe that this is a part of TD optimizing their capital structure and will still redeem expensive rate resets when they come due.

In Q3 the Nicola Private Debt Fund returned 1.6% (or 2.2% before accounting for FX). USD investments account for approx. 31% of the Nicola Private Debt Fund, so the weakening USD negatively impacted returns by 0.6% during the quarter. New investments during the quarter included Project Karma, an $18.0 million co-investment in senior priority participation in a pool of first-lien corporate loans. The Nicola Private Debt Fund also made a new US$17.0 million commitment to a distressed debt fund managed by Fortress Investment Group during the quarter.

The S&P/TSX was -2.0% while the Nicola Canadian Equity Income Fund was -2.2%. Weak performance in Energy and Financials were the largest negative contributors to Index returns in September. Strong performance for our fund in Utilities was more than offset by weak stock selection in Industrials and Materials which led to the slight underperformance for the month. The top positive contributors to the performance of the fund were Brookfield Renewable, Cargojet, and Northland Power. The largest detractors were Ag Growth International, Interfor, and SSR Mining. In September, we sold the Guardian Capital Group. We added a new position in Constellation Software.

The S&P/TSX and the Nicola Canadian Tactical High Income Fund were both down -2.0% for September. The Nicola Canadian Tactical High Income Fund benefited from strong performance in utilities and materials offset by weak performance in industrials and consumer staples. The Nicola Canadian Tactical High Income Fund has a Delta-adjusted equity exposure of 88% and the projected cash flow yield on the portfolio is over 8%. In the month, we added to our exposure in the Technology sector by adding Constellation Software.

The Nicola U.S. Equity Income Fund returned -2.1% vs -3.8% for S&P 500. The Nicola U.S. Equity Income Fund outperformed the benchmark by being overweight the consumer staples and industrials sector while being underweight the FAAMG stocks (Facebook, Apple, Amazon, Microsoft & Google) which detracted over 2% from the S&P 500’s returns. During the month, we trimmed some of our strong performing names (Deere & Lowes) and sold our only E&P energy name (EOG Resources) and redeployed into new names which will benefit from the secular surge in e-commerce (FedEx) and the secular growth in electrification of vehicles (Aptiv). We also added a new position in TJX Companies (owns Winners, HomeSense, Marshalls, TJ Maxx, etc.) that will benefit from the economy reopening and more cost-conscious consumers. The Nicola US Equity Income Fund wrote 3 covered-calls on Apple, Proctor & Gamble and Tractor Supply. The Nicola U.S. Equity Income Fund ended the month 6% covered. The Nicola U.S. Equity Income Fund has a delta-adjusted equity exposure is 98% and the current annualized cash flow is 2.9%.

The Nicola U.S. Tactical High Income Fund returned -1.0% vs -3.8% for the S&P 500. The Nicola U.S Tactical High Income Fund outperformed the benchmark due to being underweight FAAMG stocks (Facebook, Apple, Amazon, Microsoft & Google) which detracted over 2% from the S&P 500’s returns; Apple alone was down over 10% for the month which detracted close to 70bps in performance.
We continue to reposition the portfolio by adding 6 new names to the Nicola U.S. Tactical High Income Fund which include Boston Scientific, Amazon, Medtronic, Visa, Google and Progressive Corp. With Tech stocks selling off it was a good time to take advantage of the volatility and reduce our underweight. Options trading activity was significant in September as option volatility had picked up especially around the November option expiries. We wrote 43 Put options ($83MM notional amount) and 17 Call options. The Nicola U.S. Tactical High Income Fund ended the month having 48.5% of long positions covered and delta-adjusted equity exposure of 44%.

The Nicola Global Equity Fund returned +0.3% vs -1.2% for the MSCI ACWI Index (all in CDN$). The Nicola Global Equity Income Fund outperformed the benchmark due to being overweight in Japan & Emerging Asia while being underweight in the U.S. From a sector level perspective, the Nicola Global Equity Income Fund benefited from being underweight Information Technology and overweight Consumer Staples and industrials. Our emerging market managers, large-cap growth (benefited from healthcare and Japanese stocks) and defensive manager (consumer staple heavy) led the returns last month.

Performance of our managers in descending order was Pier 21 Worldwide Equity +1.3%, BMO Asian Growth & Income +1.3%, Pier21 Global Value +1.1%, JP Morgan Global Emerging Markets +1%, Lazard Global Small-cap -0.9%, Edgepoint Global Portfolio -0.1% and NWM EAFE Quant -0.1%.

The Nicola Global Real Estate Fund return was +1.3% in September vs. the iShares S&P/TSX Capped REIT Index (XRE) -0.9%. The currency was a tailwind for fund performance as the C$ was relatively weak in September and 50% of the Nicola Global Real Estate Fund is denominated in non-Canadian currency. YTD, the publicly-traded REITs have lagged the broader Canadian market by a wide margin and we are bullish on the real estate complex in the long-term. We believe that the sector trades cheaply and that the yields are sustainable. However, volatility for the REITs likely remain elevated in the near term as investors weigh the positives as the country eases lockdown measures versus 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 those areas in the portfolio. There were no new names added or subtracted in August.

The Nicola Private Equity Limited Partnership returned +2.0% during Q3. Our Nicola Private Equity Limited Partnership investment in Partners Group Private Equity II, and co-investment in a London-based insurance company, Convex, were key contributors to performance. The pool had approximately 56% of investments denominated in USD during the period, thus a weaker USD had a negative -1.1% impact on returns. New investments during the quarter included a co-investment in Decowraps, a Miami-based floral packaging company servicing large US grocers, which we acquired alongside our Boston-based PE manager Palladin Consumer Partners.

The end of September marked the Nicola Sustainable Innovation Funds first full year (9/27/2019 inception) and despite a volatile year, returns have been resilient. The Nicola Sustainable Innovation Fund returned +2.5% (USD)/ +4.6% (CAD) in September and has returned +23.4% (USD)/ +26.6% (CAD) year-to-date. BYD Co., Sunrun Inc., and Brookfield Renewable were the top contributors to performance while Pinnacle Renewable, Alstom, and Ballard Power Systems were among the detractors. One additional name was added this month: Plug Power a leader in hydrogen fuel cells that has recently been expanding its efforts into building a green hydrogen network through strategic partnerships with Brookfield Renewable and Apex Clean Energy. During the month we took some profits from Sunrun which has been on a phenomenal run year-to-date and topped up positions in EDP Renewables, Xebec Adsorption, Ormat Technologies and Hannon Armstrong among others.

The Nicola Infrastructure and Renewable Resources Limited Partnership returned 1.3% for the third quarter of 2020 in USD terms. Currency contributed 0.4% to returns as the Canadian dollar strengthened during the quarter. Cash slightly increased with distributions during the quarter and remains elevated at approximately 44%. Our investment in the EagleCrest Infrastructure fund which we had anticipated to be deployed this quarter has been pushed back to Q4 2020. We remain excited about the prospects and diversification of deploying capital immediately to over 30 mature, stable assets in the United Kingdom, United States, Canada, and Spain. During the quarter, Brookfield partnered with other prominent infrastructure investors, including the Ontario Teacher’s Pension Plan Board and entered an agreement with the Abu Dhabi National Oil Company. The deal includes a stake in the lease rights to 38 gas pipelines covering a total of 982 km. In September, we increased our commitment to Brookfield Super-Core Infrastructure and MIRA Infrastructure Global Solutions II as we look to optimize the deployment of capital to reduce our cash levels.

The Nicola Alternative Strategies Fund returned 2.7% in September. Currency contributed 1.3% to returns as the Canadian dollar weakened through the month. In local currency terms since the funds were last priced, Winton returned +1.0%, Millennium +1.5%, Renaissance Institutional Diversified Global Equities Fund -2.3%, Bridgewater Pure Alpha Major Markets -0.5%, Verition International Multi-Strategy Fund Ltd +1.3%, RPIA Debt Opportunities +1.6%, and Polar Multi-Strategy Fund +2.6%. Arbitrage based strategies continue to post strong returns benefitting from higher volatility. Convertible bond arbitrage contributed strongly to returns as the equity hedges directly benefit from increased volatility.

The Nicola Precious Metals Fund returned -5.7% for the month while underlying gold stocks in the S&P/TSX Composite Index returned -4.3% and gold bullion was down -2.1% in Canadian dollar terms. Gold continued its pullback during the month with small-cap names bearing the brunt of the weakness. Freegold Ventures and Oceanagold were both down more thanThe M 30% for the month contributing to the relative weakness.

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.