Market Commentary: A Peek Behind the Mask, the Impact of Coronavirus on the Markets.


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were +1.1% in the month of January.  The Nicola Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of Nicola Wealth Pooled Funds and Limited Partnerships.  Actual client returns will vary depending on specific client situations and asset mixes.

The Nicola Bond Fund returned +0.8% in January. Corporate spreads overall were flat to slightly tighter for the month with financials, particularly the shorter dated auto finance sector leading the narrowing. While we remain short duration focused, net new issuance during the month continued to push further out the duration of the overall market. The overall rates curve flattened during the month as a more dovish Bank of Canada coupled with fears over the Coronavirus caused investors to look for more defensive positioning.

The Nicola High Yield Bond Fund returned 1.9% in January. The strong month came despite spread widening in the US. The larger scale trends seen in 2019 continued into the New Year as high quality BB names continued their divergence with CCC names while energy names were down more than 2% during the month. Energy saw a tidal wave of new issuance during the first couple of weeks of the year which has almost matched the issuance across the sector seen in all of 2019. Overall, new issuance was very active during the month with the most activity seen in the past 2 years while demand was less supportive as retail fund flows saw a net outflow during the last 2 weeks of the month. Approximately 6% of the market now trades with distressed prices (less than $80), which likely points to a pick-up in default rates. Currency added 1.0% to fund returns as approximately 50% of the fund is in US dollars which strengthened steadily during the month.

The Nicola Global Bond Fund was up 0.7% for the month. Although we do not believe there are material risks on the short term horizon with the IMF lowering its expectations on global growth this year and next, there is a potential for some market re-pricing. Overall the portfolio has positioned into a slightly more defensive posture with incrementally more exposure to risk off currencies like the Yen and some Scandinavian currencies although we still maintain select credit exposure. Manulife contributed most to returns for the month as both sector and country allocations were positive contributors to returns.

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 funds would return if all mortgages presently in the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.0% for the Nicola Primary Mortgage Fund and 5.5% for the Nicola Balanced Mortgage Fund.  The Nicola Primary Mortgage Fund had 19.3% cash at month end, while the Nicola Balanced Mortgage Fund had 14.8%.

The Nicola Preferred Share Fund returned -0.1% for the month while the BMO Laddered Preferred Share Index ETF returned 0.1%.  The market was positive during the first half of the month but reversed direction as concerns on the Coronavirus started to impact financial markets. The Bank of Canada left rates unchanged but concerns on weaker growth contributed to the 5 Year Government of Canada Bond yields falling from 1.69% to 1.28%. Technicals in the marketplace remain constructive as both Brookfield and Artis REIT have been buying back preferred shares while there has not been a new preferred share issue since May 2019, limiting supply in the marketplace. The risk off tone saw investors generally waiting on the sidelines as volumes during the month were muted and those investors participating in the market mainly focused on more defensive positions.

The S&P/TSX was up +1.7% while the Nicola Canadian Equity Income Fund was +0.8%. The Financials sector was the largest positive contributor to the Index in January followed by Information Technology. Energy was the largest negative contributor as investors fear what the impact of the Coronavirus will be on global growth.

The underperformance of the Nicola Canadian Equity Income Fund was mainly due to being underweight Information Technology, and poor results from holdings in the Consumer Discretionary category. The top positive contributors to the performance of the Nicola Canadian Equity Income Fund were Cargojet, Aritzia, and NFI Group. The largest detractors to performance were Spin Master, Methanex, and Air Canada. In January we added four new positions: Northland Power, Andlauer Healthcare Group, Open Text, and Kirkland Lake Gold. We sold Artizia and Teck Resources.

The S&P/TSX was up +1.7% while the Nicola Canadian Tactical High Income Fund was -1%. The Financials sector was the largest positive contributor to the Index in January followed by Information Technology. Energy was the largest negative contributor as investor fear what the impact of the Coronavirus will be on global growth.  The top positive contributors to the performance of the Nicola Canadian Tactical High Income Fund were NFI Group, Sleep Country and Guardian Capital Group. The largest detractors to performance were cyclical names which were hit hard: Methanex, Westshore Terminals and West Fraser Timber.

The Nicola Canadian Tactical High Income Fund is overweight in the cyclical and value sectors as option writing is usually attractive in these areas and these names underperformed in January. In January we added six new positions: Enbridge, Royal Bank, Telus, Manulife, Ag Growth, and Northland Power. We sold KP Tissue and Sleep Country.  Currently the Nicola Canadian Tactical High Income Fund has a Delta-adjusted equity exposure of 70% and the projected cashflow yield on the portfolio is 8.6%.

The Nicola U.S. Equity Income Fund returned +0.6% vs -0.04% for S&P 500. The Nicola US Equity Income Fund’s relative outperformance was due to being overweight select names in Info Tech (Microsoft & VISA), Communications (Alphabet) & Utilities (Nextera Energy).

The worst performing stocks were within the Energy, Materials, Health care & Financials sectors which were impacted by a Coronavirus uncertainty, lower interest rates and Bernie Sanders moving up in the betting markets.  Call option activity increased during the month as the Nicola U.S. Equity Income Fund took advantage of heightened volatility.  The Nicola U.S. Equity Income Fund ended the month 19% covered with a delta-adjusted equity exposure of 90%. New positions included Dollar Tree, Tractor Supply Company & John Deere.  We sold our position in Vulcan Materials and reallocated to new names above.

The Nicola U.S. Tactical High Income Fund returned +0.3% vs -0.04% for S&P 500. The Nicola U.S. Tactical High Income Fund’s relative outperformance was from two stock specific events and being underweight the worst performing sectors last month (Energy, Materials, Health care & Financials) which were impacted by a Coronavirus uncertainty, lower interest rates and Bernie Sanders moving up in polls.

Stock selection was mixed: positive contribution from select Consumer Discretionary stocks (Delphi & L Brands were involved in separate M&A discussions) were partially offset by a few names within the industrial sector (FedEx, Deere and Boeing).  Option volatility spiked 37% during the month (13.8% to 18.9% vol) and the Nicola U.S. Tactical High Income Fund was very selective in deploying capital (excess cash of 18% at the beginning of the month; 2% excess cash at month-end).   The delta-adjusted equity rose slightly from 37% to 50% and four new names were added to the portfolio: UnitedHealth Group, Walmart, Comcast and Disney.

The Nicola Global Equity Fund returned +0.3% vs +0.5% for the iShares MSCI ACWI ETF (all in CDN$).  The Nicola Global Equity Fund slightly underperformed due to country/region mix (underweight U.S., overweight Asia) and our underweight in Info Tech; however, these were largely offset by our overweight in Consumer Defensive companies through Valueinvest and by our growth-focused manager, C Worldwide.  Performance of our managers in descending order was C Worldwide +2.0%, ValueInvest +1.6%, Lazard +0.4%, NWM EAFE Quant -0.6%, Edgepoint -0.9%, BMO Asian Growth & Income -1.6%.

The Nicola Global Real Estate Fund return was +3.1% in January vs. the iShares (XRE) +4.5%. Publicly traded REITs had a strong month after a down month in December.  10 year Canada bond yields declined in the month from 1.70% to 1.27% as investor worry about global growth and the low interest rate environment is positive for real estate and property level fundamentals are improving.

The Nicola Global Real Estate Fund also benefited from a strong USD which appreciated 1.9% vs. CAD in January. We added Artis REIT to the portfolio this month.  We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of January 31st, December 31st  performance for the Nicola Canadian Real Estate LP was +1.3%, Nicola U.S. Real Estate LP +0.8%, and Nicola Value Add LP +0.2%.

The Nicola Alternative Strategies Fund returned 2.2% in January.  Currency contributed 1.2% to returns as the Canadian dollar weakened significantly through the month. In local currency terms since the funds were last priced, Winton returned 0.5%, Millennium 1.3%, Renaissance Institutional Diversified Global Equities Fund -0.2%, Bridgewater Pure Alpha Major Markets 2.3%, Verition International Multi-Strategy Fund Ltd 1.4%, RPIA Debt Opportunities 1.4%, and Polar Multi-Strategy Fund -0.1%. Broadly speaking strong returns overall for the fund with Bridgewater’s overall long net exposure to global equity markets being supportive to returns.

The Nicola Precious Metals Fund returned 3.0% for the month while underlying gold stocks in the S&P/TSX Composite index returned 2.9% and gold bullion was up 6.7% in Canadian dollar terms. RBC Global Precious Metals lagged the overall gold equity market as Wesdome Gold mines reversed course during the month and gave back some returns from its torrid pace over the past two years.

Both Detour and Kirkland were larger detractors over the month as well. Kirkland announced intentions to acquire Detour in November 2019 and the deal was completed recently. Both names sold off during the month as the transaction came to completion but we remain constructive on the acquisition and Kirkland.

 

January in Review

The strong market momentum we saw at the end of 2019 carried through to the New Year as most markets continued to melt slowly higher in January.  So consistent was the market’s performance, in fact, that one needed to go back as far as October 15th to find the last time the S&P 500 had more than a 1% daily move, either up or down.

This unusually “quiet” streak was broken on January 27th when the S&P 500 fell nearly 1.8%.  What was behind this extended 70 day period of calm, and what caused it to be interrupted?  As we discussed last month, the trade truce between the U.S. and China and an accommodative Federal Reserve have helped create a “risk on” environment in global capital markets.  Both these factors should help stabilize global growth in 2020 and increase investor confidence.  If anything, concerns the enthusiasm of the market advance would soon outstrip the more positive economic fundamentals was more on investor radar screens than threats of a recession and declining earnings.

 

How will Coronavirus impact the markets?

It was uncertainty around the Coronavirus, more formally known as 2019-nCoV that caused the market to turn lower in late January. It’s still too early to forecast the ultimate impact 2019-nCoV will have, but most believe the damage will be confined mainly to China and only impact the first quarter.

At best, 2019-nCoV could have helped give the markets a needed breather before continuing its march higher. At worst, it could be the start of a recession and a bear market.  We  think the former is more likely and will spend the rest of this commentary delving a little deeper into the Coronavirus and its impact, as well as checking in on other market drivers like the U.S. election, which is starting to heat up.

 

Geopolitics were on investor radar screens.

While the Coronavirus caught the market off guard, Geopolitics was on investor radar screens. It was the growing threat of a military conflict between the U.S. and Iran that investors were focused on in early January.

A U.S. drone killed a top Iranian General in Iraq and Iran retaliated by launching a missile attack on U.S. bases.  Market reaction was fleeting with a brief correction quickly erased as both countries appeared motivated to de-escalate and ease tensions in the region.

Continued protests in Hong Kong and a landslide election result in Taiwan resulted in the re-election of anti-reunification President Tsai Ing-wen (throwing cold water on China’s “one county, two systems” aspirations for the country). This made little impression on the steady march higher for markets.  Not even the announcement from Prince Harry and Meghan Markle, the Duchess of Sussex, and their intention to step back from their royal duties was enough to shake the confidence of traders.

We throw this one in there not only to lighten the mood a little, but to fairly point out it did dominate the news channels early in the New Year.  The fact that the happy couple might settle in Canada made the story even more all-consuming.  Perhaps more seriously, the Australian wildfires also dominated headlines and will have a far greater impact on the markets over the longer term as climate change becomes an important topic for investors to consider.  While certain alternative energy stocks and sectors were positively impacted, the wildfires didn’t seem to trouble the broader markets overall.

While the outbreak was first officially reported to the WHO on December 31, it is believed to have originated in a seafood and meat market in Wuhan China earlier in the month, or even November.  The speed in which the virus has spread and China’s swift reaction has been unprecedented.

On January 23rd Wuhan, the epicenter of the outbreak and a city of 11 million, was locked down, quickly followed the next day with nearly the entire province of Hubei and it’s over 50 million inhabitants coming under quarantine.  The closest comparison the market has to weigh the severity of the Coronavirus outbreak is SARS, which originated in Southern China around November 2003 and eventually infected over 8,000 people worldwide causing 774 deaths.  The good news with the Wuhan Coronavirus is that the fatality rate is much lower, but it has spread much more quickly, likely because the incubation period is much longer and those infected can spread the virus before even showing any symptoms.

The hope is the virus remains largely contained to Wuhan and slowly burns itself out by the end of March.  The key is the number of daily new cases.  Once the peak has been confirmed, the markets will become more confident that the damage can be more accurately assessed.  Goldman Sachs recently forecast a 1.6% hit to China’s first quarter GDP growth resulting in a 6.4% quarter on quarter annual rate decline.

In layman terms, this would mean Q1 Chinese GDP would be essentially zero.  The negative impact just from a reduction in Chinese growth could take 1% off global growth, however spillover effects to the rest of the world would likely result in a 2% overall hit.  If the impact is confined to Q1, the reduction to global growth for 2020 might be only 0.1 to 0.2%.  A horrific and scary event for China and those affected, but an event the market will likely look past.  Let’s all hope this is the case.

 

Complications to the U.S./China Trade War.

Apart from the negative hit to global growth, the timing and negative impact of the virus also complicates one of the positive drivers for the market rally, the trade deal between the U.S. and China.  President Trump and China’s Vice Premier signed the first phase of the U.S.-China trade agreement on January 15th, in which China has committed to buy an additional $200 billion of U.S. goods over the next two years. Hitting these targets was always going to be a stretch given it is projected to take America’s share of total Chinese imports from 9% to 17% (based on 2017 totals), but given China’s economy has ground to a virtual standstill, progress on these targets is likely to lag expectations.

If President Trump is looking for an out on the deal, he will likely get an opportunity by claiming China isn’t living up to their side of the bargain.  Trump will probably cut China some slack, however.  While the market has largely discounted the positive impact of the trade deal, corporate America has not.  Trump needed the trade deal to ensure the economy remained on track leading up to the November election.  It’s in Trump’s best interest to let business confidence heal and hope capital spending recovers.  If anything Trump could actually lower tariffs if the impact of the virus hurts global growth more than expected and threatens the U.S. economy.

From President Trump’s perspective, status quo is pretty good right now.  In fact, the Donald probably had his best week as President in early February.  The Senate acquitted Trump on articles of impeachment, Gallup reported his approval rate hit 49%, the highest since he took office, 63% approve of his handling of the economy, and a J.P Morgan study showed the economic backdrop is at the highest level of any incumbent President running for re-election since 1900.

 

It gets better (for Trump that is).

On February 3rd, the Democrats kicked off their official nomination process with the Iowa caucus, and it was a complete disaster.  As we write, we are still not sure who the winner was, though it is likely that President Trump will be declared the only real winner!  Problems with a voting app and irregular totals resulted in an inconclusive result that robbed both Bernie Sanders and Pete Buttigieg, the two eventual front runners, the momentum normally ascribed to the victor of the Iowa Caucus.

Sanders looks to have won the popular vote, but may have been edged out by Buttigeig in the delegate count.  It is close.  This is significant because Sanders is expected to do well in the New Hampshire primary on February 11th, and according to Strategas, no candidate from either party has won two of the first three primaries and not gone on to win the nomination.

More problematic for the Democratic establishment, however, was Joe Biden finishing well back in fourth place.  Biden was running neck and neck with Bernie Sanders according to polls, but faded badly, gaining less than 14% of the Iowa delegates.  Biden has campaigned on the idea that Trump can’t be allowed to serve another four years and he was the best chance to prevent this from happening.  The fact he came in fourth in Iowa raises serious questions about whether this is true, or if Pete Buttigeig, the 38 year old Mayor of the fourth largest city in Indiana is the best person to take on Trump.

The prospect of Biden dropping out of the race and Bernie Sanders becoming the front runner presents a huge problem for the Democratic Party establishment.  Sanders is a self-declared “democratic socialist” in a country where, according to a recent NBCNews/Wall Street Journal survey, only 19% of registered voters expressed positive views of socialism versus 53% negative, including 41% who were very negative.

Don’t think President Trump doesn’t know this and will make it the focus of his campaign if he goes against Sanders.  The problem for the Democrats is those 19% are Sanders’ base and they are likely to walk away if he doesn’t become the nominee.  Democrats don’t want Sanders, but they need his supporters.  Democrats might not agree with his policies, but no one in the field is able to energize their base like the 78 year old Senator from Vermont, certainly not sleepy Joe.

Many feel the Democrats erred in 2016 by alienating Sanders and his followers during the heated nomination battle in which Hilary Clinton ultimately emerged as victor, only to be upset by Trump.  Referring to Sanders, Clinton was recently quoted as saying “nobody likes him; nobody wants to work with him”.  This sounds like sour grapes from a beaten and humiliated Clinton who felt Sanders stayed in the race too long and weakened her chances of beating Trump, or a jab from a Democratic party insider concerned Sanders could win the nomination and destroy any chance of the Democrats taking back the White House in November.

Likely a bit of both, we would point out nobody liked or wanted to work with Trump either, but that didn’t stop him from becoming President.  According to BCA Research, the U.S. is moving towards the left with more Americans believing the Government should be taking a larger and more active role.  Sanders’ policies, like Medicare for all, the cancellation of student debt, and free tuition, were considered radical in 2016 but are more mainstream now and have been endorsed by many of his running mates.  They are expensive, however, and in an economy that appears to be working, why take the risk?

A Sanders Presidency would be a disaster for the markets, and even the smallest chance of this happening is not being discounted in the market.  Interestingly, however, Sanders winning the Democratic nomination might be good for the markets if the market believes Trump has a better chance of beating Sanders than Biden or Buttigeig.

 

Michael Bloomberg, the wildcard.

There is, however, one wildcard we haven’t discussed yet, namely Michael Bloomberg.  Bloomberg strategically chose not to even put his name on the ballot for the first four Primaries, opting to wait for March 3, aka Super Tuesday, when 14 states, including delegate rich California and Texas go to the polls.  Bloomberg is being strategic, not economical.  According to RealClearPolitics the former NYC Mayor, worth an estimated $55 billion, who  is self-funding his campaign, has spent an unprecedented $301 million as of the end of January and directed his staff to ramp up ad spending even more after Biden’s poor results in Iowa.

Like Biden, Bloomberg is a moderate who believes defeating Trump is job one.  He is aware splitting the moderate vote with Biden could hand the nomination to Sanders and ultimately a victory to Trump.  By taking a pass on the early primaries, Bloomberg positions himself as the alternative if Biden falters, which it looks like he has.  Unlike the other candidates, Bloomberg can stay in the race as long as he wants.  Bloomberg is said to be willing to spend $500 million on the Democratic nomination, and up to $1 billion on the entire election, even if he doesn’t stay in the race.  Can an old white New York Billionaire become President?  Well, you know the answer to that one.  It might not excite the Democratic base, but the markets would be happy with either Billionaire. An old white socialist, not so much.  So far, the U.S. election isn’t impacting the market, but it is early days and it has the potential to be the number one issue for investors in 2020.

 

Global growth looked to be turning a corner.

In the meantime, the economy is what investors will likely be focused on, and up until the Coronavirus outbreak, global growth looked to be turning the corner.  Manufacturing indices in Asia, Europe and the U.S. appeared to be inflecting higher in January, and a strong job market in the U.S. is keeping consumer confidence high and insulating the U.S. economy from geopolitical issues like the U.S. China trade war.  U.S. stocks moved higher last year despite flat corporate earnings.

Valuations increased as the Fed lowered rates in an attempt to stimulate the economy.  This year, earnings are expected to do more of the heavy lifting as the Fed stays on the sidelines.  How investors discount the impact of the Coronavirus and Sanders’ rise in the polls could determine how this scenario plays out.  Low interest rates and simulative financial conditions are a powerful elixir for the market, but uncertainty tends to have the opposite effect.  We have a lot of both so far this year.

 

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.