Highlights this Month
- The scoop on quantitative easing.
- How are low-interest rates impacting businesses?
- The upcoming US election and what it means for the economy.
- Can investors find refuge in gold as they have in the past?
- Where does the US dollar’s reserve currency status stand?
July In Review
This month we thought we would take a bit of a break from the pandemic, a sort of summer holiday if you will (maintaining proper social distancing, of course). While we expect COVID-19 will be with us at least until the end of 2020, we want to look beyond the pandemic at what the financial world may look like once social distancing measures can be fully relaxed and life is able to resume its pre-pandemic path.
While we expect the economy to take several (or more) quarters to fully recover, and history will show its overall impact on the economy to be profound, it is likely the legacy of the pandemic will be that it served to accelerate trends already in place rather than establish new ones. For example, work-from-home and e-commerce trends were already firmly in place; the pandemic only magnified their adoption rate. Even greater than the more micro-impact on specific businesses and industries will be the impact on the broader economy post the pandemic. More specifically, how economies deal with the huge amounts of debt issued to finance, epic budget deficits and what this means for inflation and interest rates.
The pandemic will only make inequality worse.
Over the last 30 years, inflation and interest rates have moved lower, and governments, corporations, and individuals have become more indebted. For individuals, higher debt levels were also indicative of a growing wealth gap as the rich were accumulating more assets while everyone else needed to fall further into debt in order to keep up. The pandemic will only make inequality worse. Will we start to see a reversal of these trends in the post-pandemic world, or an acceleration? Will the fortunes of Main Street finally start to turn at the expense of Wall Street? Definitely some good summertime topics to ponder.
While we expect economic growth to continue to recover as economic lockdowns ease until a vaccine is widely available, monetary and fiscal stimulus will remain in place; keeping interest rates anchored near zero and government debt levels rising. At some point, however, it would seem logical there would be a cost associated with them both.
The scoop on quantitative easing.
Last month we discussed how markets are being distorted by low-interest rates such that capital is no longer being efficiently allocated and the market’s price discovery mechanism is impaired. This is a concern. As well as keeping overnight rates low, however, the Federal Reserve is also lowering longer-term yields by purchasing bonds (also known as quantitative easing or QE for short), mainly government, mortgages, and investment-grade corporate debt. The Fed purchases the bonds from Banks, paying them by crediting the Bank’s reserve accounts at the Fed. As a result, the Fed is effectively creating (printing) money, which many fear will eventually lead to inflation. More money, the same amount of goods, should result in higher prices. It’s Economics 101, or so we thought.
As we now know from observing the impact of QE during the Great Financial Crisis (GFC), the increase in money supply only impacts the economy if the banks convert their excess reserves into loans, something they didn’t do in the GFC. This is why the vast amount of quantitative easing and money printing did not lead to inflation. Money supply went up but because the banks didn’t do anything with it (the Fed pays them an interest rate on their excess reserves), the money multiplier went down and money wasn’t actually created (or printed). You can’t force people to borrow or lend money if they don’t want to. We have seen loan growth during the pandemic spike higher, and monetary base with it, but this is likely due to US corporations increasing liquidity while they can due to the uncertainty around the pandemic.
Given the velocity of money continues to turn lower, we don’t see these loans impacting the money multiplier and leading to a sustained increase in inflation. As long as the money being created by the Fed doesn’t make its way to the real economy, there is really no limit to how much debt the Fed can buy and how long they can keep rates low. According to Chairman Powell, the Fed has unlimited firepower, and, from this perspective, he is right. There are limits to their power, however. If the money doesn’t get into the real economy, it may bid up the price of financial assets but it doesn’t actually generate economic growth.
While there may be limits to monetary policy and the Fed’s ability to use it to generate economic growth, the Fed can also play an important role in facilitating fiscal policy. By keeping interest rates low, the Federal Reserve enables the Federal Government (US Treasury) to incur massive deficits allowing government debt levels to spiral higher; this gets into the real economy and it does generate economic growth. While government debt has soared to post-WWII records and many rightfully begin to ponder how the debt can ever be re-paid, the carrying cost of the debt has not increased given interest rates are near zero. Taken at its extreme, the burden of higher debt is negligible if the cost to service the debt is near zero. As long as the Federal Reserve stands by as a ready buyer of the debt the US Treasury will need to issue, the situation would appear to be sustainable.
The Fed is supposed to be independent in fulfilling its dual mandate of keeping inflation under control and employment full, but no one can argue the Fed has failed in its duties by ensuring there still is a US economy to recover from once the pandemic has run its course. The true test of their independence, however, will come in the future if government debt levels remain on their upward trajectory. As far as dealing with the pandemic, however, monetary and fiscal policy appears sustainable and appropriate.
There are limits, however. The idea that that there are no consequences to running up debt levels, while appealing, defies the laws of economics, markets, and logic. It’s certainly the case for individuals and companies and will eventually be true for countries and governments as well. Debt is a claim on future earnings and allows one to consume today at the expense of consumption or savings in the future. Some debt is good, especially if it is used for productive investment or the good of society, like the current pandemic government deficits and spending. Debt levels were rising before the pandemic, however, as Hoisington Investment Management’s Lacy Hunt has persistently maintained, higher levels of debt have provided diminishing marginal returns in terms of economic growth; meaning higher and higher debt levels are providing lower and lower growth rates in the economy.
A recent WSJ article by Ruchir Sharma entitled, “Rescues Ruining Capitalism” argues constant government stimulus has not only undermined free markets but has resulted in low growth and productivity. In the article, Sharma references a 2011 European Central Bank Paper showing a significant negative effect on per capita GDP growth from bigger governments in 108 countries over the past four decades. A BCA Research report found a similar relationship in 28 countries over the past two decades, including in the US. More debt is not a solution for too much debt especially if it flows to unproductive projects. The debt is being misallocated and wasted, akin to money being thrown down a hole.
How are low-interest rates impacting business?
At the corporation level, another impediment to growth might also be low-interest rates themselves. Given GDP growth is the sum of population growth and productivity growth, and we don’t see population growth helping the cause any time soon, productivity needs to be the driver. An argument could be made we are on the cusp of seeing a new wave of technology-driven productivity that will more than compensate for the negative impact of high debt levels and drive growth higher. Rather than help facilitate this transition, however, easy money and stimulus might actually help maintain the status quo, hindering the formation of new innovative companies and investment. While it is true low-interest rates make it easier to invest in innovation, this is the case for large companies as well as small startups.
According to a 2019 Project Syndicate article, while low-interest rates incent productive capital investments, the incentive is greater for market leaders than followers leading to higher market concentration and a trend toward more monopolistic industries. Essentially, the underdogs get discouraged and quit trying and the result is fewer startups and healthy competition. At the same time, low-interest rates and abundant liquidity keep unprofitable “zombie” companies alive.
One of the hallmarks of capitalism is creative destruction with unprofitable businesses making way for new innovative entrepreneurs. With low rates, creative destruction is being replaced by monopolies with high-profit margins and little incentive to innovate. On the positive side, there is growing bipartisan support in Washington against large technology platform companies from both a privacy and anti-trust perspective. How this plays out in the future, particularly given these companies tend to be national champions in a world that is becoming more bipolar, is uncertain. Any anti-trust initiatives coming out of Washington could have future benefits for innovation and thus productivity growth but would be negative for the market given big tech’s dominance in most major US indices.
Based on the prospect of more debt in the post-pandemic world and slower economic growth, the US looks destined to suffer the same fate as Japan where growth and inflation have been stagnant for decades and nominal interest rates are anchored at zero, or below. But what if policymakers don’t accept the Japanification of the US economy? What options do they have to stimulate growth? On the monetary policy side, not many, given nominal overnight interest rates have been getting progressively lower and it took only 10 months during this cycle for rates to go from peak to the zero bound. A solution could be a move to negative nominal overnight rates, like in Europe and Japan where negative overnight rates have translated into negative-yielding government bond yields.
While one can rightfully challenge the logic of negative interest rates altogether, the efficacy in Europe and Japan has been suspect. Sweden’s Riksbank, the world’s oldest central bank and the first to take its overnight rate below zero in 2015, has already announced their intention to end the experiment citing concerns over higher household debt and soaring home prices, as well as an inflation rate that continues to trend below target. Even though the Fed has said they are not planning to go to negative rates, for now, futures markets are starting to price-in negative overnight rates in the future.
We suspect the Fed will keep rates zero-bound for an extended period of time but we take the Fed for their word and rates in the US will not go negative; the impact on financial institutions, like insurance companies would be profound. Also, the US has a well-developed money market funding infrastructure that would be unviable with negative interest rates.
The other option with monetary policy is more quantitative easing but, as stated above, while Central Bank asset purchases help bid up the price of financial assets, it doesn’t directly increase economic growth. It makes investors and Wall Street wealthier but Main Street America doesn’t have much of an investment portfolio so they largely miss out. Despite its lower marginal return on growth, fiscal policy is where policymakers hope they can both stimulate growth and address inequality making it very appealing from a political perspective.
While the wealth gap was already on an unsustainable path the pandemic has made it even worse. Globalization and automation have been consistently eroding labour’s share of economic output over the past couple of decades such that the average US worker has seen virtually no increase in real income; this is unsustainable both economically and politically. From an economic perspective, lower-income consumers have a higher marginal propensity to spend meaning they are more likely to spend an extra dollar of income while wealthier consumers will save more.
The upcoming US election and what it means for the economy.
Based on where interest rates and economic growth are today, it’s not hard to argue we need more spending and less saving. Given markets don’t appear to be making the adjustment, we are likely to see governments try their hand at re-distributing income. With the US election November 3rd fast approaching and a Democratic sweep looking more likely, expect a more progressive Biden Administration to increase spending. Biden has promised $2-trillion in green infrastructure spending and, while Medicare for all might not happen in the short-term, expect movement in this direction. Other favoured Democratic policies include free college tuition and student loan forgiveness. Big-ticket programs that were once more aspirational given their price tag could now be on the table. As long as central bankers are willing to join the team and put their independence aside by ensuring bond yields remain very low, fiscal spending could be the answer to everyone’s economic problems. Well, maybe not everyone’s. Taxes are going to go up, especially for the companies and the wealthy. Biden has stated he will raise corporate taxes from 21% to 28% which is bad for corporate earnings and thus stock prices. An estate or wealth tax is also possible. The bottom line, some of the move towards greater equality is going to come from making the rich less wealthy.
Even before the pandemic, no one in Congress was talking about reigning in America’s growing debt level. After spending $3-trillion and counting on aid during the pandemic, it has become harder to argue the money can’t be found. As it was with monetary policy, the biggest concern with out-of-control government spending is the eventual risk of higher inflation. With the economy operating well below capacity, however, it is unlikely inflation will move higher in the short-term. Some supply chain disruptions could see prices on certain goods increase (like food prices) but deflation remains more likely in the short-term.
More government debt looking for a home could crowd out private investment, leading to higher interest rates, but with the Federal Reserve playing the role of buyer of last resort and actively ensuring rates stay low, the path to even higher government debt becomes clearer. Also, as the world’s reserve currency, there is a healthy foreign appetite for US debt. Over the next few years, after the pandemic, low rates and higher government spending could become the norm which would be good for economic growth and Main Street USA.
It’s a good thing higher debt levels aren’t an inflationary threat in the short-term because no matter who wins in the upcoming US election, debt levels are likely going higher. While a Democrat-controlled administration is more typically associated with higher government spending and the upcoming US election could provide a catalyst given the likely “blue wave” come November 3rd, Republicans also like to spend money and a Trump second term would likely see the same increase in debt, just spent a different way.
While this is good in the short-term, once the economy recovers, either government spending will have to be curtailed or inflation will eventually start to rise. Unlike quantitative easing, which only increases the demand for financial assets, the fiscal policy increases spending and will eventually lead to a mismatch between supply and demand, and result in inflation.
Traditionally, the Federal Reserve has targeted 2%, but they have consistently fallen short over the past few targets. As a consequence, the Fed has indicated they might be inclined to let prices run a little hotter in order to compensate for the time inflation has spent below their 2% target. With a higher inflation rate, even if nominal rates stay zero-bound, real rates can continue to fall well below zero, thus helping to ease financial conditions and stimulate the economy.
Alternatively, if real rates were left unchanged higher inflation would give the Fed more room to stimulate the economy in the next recession by lowering rates again given higher inflation would also increase nominal interest rates. As far as the Fed is concerned, a little inflation is a good thing.
Letting inflation run higher may be appealing to the Fed in the short-term, but it is a dangerous game, and if the Fed gets too far behind the curve and loses control, inflationary expectations can increase and more drastic measures may be needed to get prices back under control. This was the case in the 1970s, and it ended poorly in a severe recession and bear market.
As mentioned above, we are not concerned in the short-term with traditional inflation indicators like Consumer Price Index (CPI) remaining under control. We would be remiss, however, if we did not point out some other indicators to the contrary. With CPI, it is likely the basket of goods used to calculate the index is not indicative of how consumers are actually spending their money. For example, food prices have risen and are presently taking a larger share of the typical consumer’s paycheck given eating out is severely restricted, so real CPI would be higher if the basket were adjusted to include actual spending.
We are also starting to see some financial indicators typically associated with higher inflation signal higher prices might be in our future. Gold has started to rally, but maybe even more significantly, so has copper which is typically used as a barometer for global growth. Also moving higher has been breakeven rates on inflation-protected notes, though they are still at fairly depressed levels. A steepening yield curve might also provide some ominous clues for the future direction of inflation. While it is assumed the Federal Reserve will cap short-term yields at low levels, the Central Bank has historically had less influence over longer-term rates and a steepening yield curve could indicate higher yields and inflation down the road. Regardless, it’s hard to get too worked up about inflation when unemployment is over 11% and the economy is running well below capacity.
Longer-term, inflation concerns become more problematic for the Fed as one of the biggest drivers of lower inflation over the past few decades may be set to reverse, namely globalization. The US/China trade war is only in its early innings and while we don’t expect supply chains to be entirely re-shored, it is reasonable to expect some manufacturing will be brought back to the US.
One of the legacies from the pandemic, when it comes to supply chains, will be resiliency over cost. This will be good for the American worker, though expect automation to reduce the number of new jobs that will be created. It will, however, mean prices could move higher. Demographics and an ageing population are commonly believed to reduce inflation which could offset some of the impacts of de-globalization, but we are not so sure. It’s logical that as we grow older and consume less, prices would decline as demand falls and economic growth slows, but this assumes a constant level of supply.
More likely, however, an older population and higher dependency ratio means there will be fewer workers to support a growing population of retirees causing labour costs to rise. Also, it is not a given people consume less as they age given health care costs alone tend to spike higher. Bank Credit Analyst, in particular, believes ageing demographics could cause inflation to increase, a theory backed up by a February 2015 BIS Working Paper by Mikael Juselius and Elod Takats called “Can demography affect inflation and monetary policy” which looked at the experience of 22 countries from 1955 to 2010. The paper found a stable and significant correlation between demography and low-frequency inflation. The larger the share of dependents, both young and old, the higher inflation tended to be.
As mentioned earlier, some inflation would be a good thing. Central banks in developed market economies have been trying to create inflation for years. It’s not so good, however, if it leads to higher nominal interest rates at the same time debt levels are moving materially higher. This cannot happen, and to make sure it doesn’t happen, the Federal Reserve will need to be on board to ensure nominal rates remain low.
If nominal rates are capped at low rates and inflation moves higher, debt becomes even more manageable. Nominal economic growth increases as inflation increases, while debt levels and the carrying cost of debt in real terms declines. This is the classic playbook on how debt is eventually reduced; interest rates are kept artificially low (aka financial repression) while nominal economic growth increases due to government spending and inflation such that GDP grows faster than debt. This is essentially what happened after World War II, though one could argue the US had the economic tailwind of being the world’s only remaining source of manufacturing capacity and the ability to rapidly shift from a wartime economy to a consumer-led economy. Not saying the US can’t grow their economy by increasing their industrial economy and exports as they did after WWII, but there are some major obstacles in their way, namely China and Germany (Euro-zone).
In a recent book by Michael Pettis and Matthew Klein called “Trade Wars are Class Wars.” the authors make the argument under-consumption in countries like China and Germany have resulted in a global savings glut that has lowered real interest rates and inflation. They also make the case it has caused income and wealth to become more concentrated in China, Germany, and the US.
In China, state-owned enterprises controlled by the party elite are favoured over the underpaid worker. Similarly, in Germany, companies and landowners have prospered at the expense of workers and infrastructure spending. Alternatively in the US, domestic manufacturers have been squeezed and good-paying industrial jobs moved offshore. As an offset, Americans have access to cheap debt in which to maintain their lifestyle. While it is a true rebalancing of the American economy away from consumption and debt and towards investment and manufacturing would be put the US on a more sustainable path, it can’t happen unless China and Germany commit to doing the opposite.
De-globalization would potentially take the decision out of their hands but result in lower global economic growth for everyone. For the US, some higher-paying industrial jobs for American workers might return, assuming they are not automated, but the negative would be the loss of access to cheap funds and low-interest rates. Take away the imbalance of big trade deficits and you also lose the savings glut and cheap money. This would put even more pressure on central banks in their mission to keep rates low. The combined upward pressure on both real interest rates (end of the savings glut) and inflation will eventually be too much for the Fed to contain. At some point in the future, interest will be headed higher, the only question is when.
In the meantime, an environment of higher inflation does not have to be bad for investors, especially if nominal yields are kept in check by the Central Bank. As long as companies are able to pass through price increases to their customers, equities are actually a good hedge against inflation. Cash flows move up with inflation and the present value of those cash flows is discounted by flat or even declining real interest rates.
The same logic holds for real estate. What is a less optimistic scenario is one wherein an attempt to reduce inequality. Fiscal spending not only drives deficits and debt higher, but it is allocated inefficiently; and while it fails to lift economic growth, it does succeed in increasing inflation and lots of it. This results in stagflation and is the worse scenario for investors, especially those holding fixed income. Bond yields move higher, which is bad news for government bonds, and corporate credit spreads widen as economic growth stalls. For equities and real estate, the key is to pick assets that can continue to grow their cash flows. Even if the discount rates increases, higher cash flows can offset, at least partially, the inevitable decline in valuation. Historically, stocks have had a negative correlation with inflation, but faired better during the high inflation years of the 1970s and early 1980s. Real Estate has provided better protection, while long-term government bonds have predictably faired poorly.
According to George Mason University’s Derek Horstmeyer, the asset providing the best protection against inflation since 1970 has been gold; which given the strong move in the yellow metal year to date might indicate investors believe inflation could be just around the corner. We don’t think inflation is the real driver for gold, however. In fact, history shows gold doesn’t always do a good job of protecting investors from inflation. As highlighted in a May 27, 2020 report by Goldman Sachs, only when inflation has exceeded 6% has gold outperformed US Equities, and from August 1973 to July 1982 in particular. Over a 30-year time horizon, equities, real estate, and intermediate-term treasuries have all outperformed inflation a larger percentage of the time than gold; and on up to a 20-year time horizon, so have T-Bills and long-term treasuries as well. Over shorter time horizons, gold has only provided a better inflation hedge than commodities.
Can investors find refuge in gold as they have in the past?
Gold works, but only during certain times. Perhaps Ray Dalio’s May 7, 2020 paper, The Changing Value of Money, best highlights when the yellow metal tends to shine. Comparing spot currencies to gold over time, most currencies lose all their purchasing power due to inflation, but, this is only if the currency is left in cash, like under a mattress. If instead the cash is held in a short-term money market or bonds, the return for most currencies exceeds that of gold. Sure, some currencies still run into problems, like Deutsche Marks after WWI and WWII (they became worthless) but since 1850 an investor would have been better off holding US dollars invested in T-Bills than gold; same for UK Pounds and Gilts. The table below clearly illustrates the difference. Since 1850, the real return for US T-Bills has been 1.6% versus 0.2% for gold. This makes sense and is the key to understanding when and when not to invest in gold. As long as the real return in holding cash (invested in short-term bonds) is positive, it is a safer and more profitable investment than gold.
Real returns of currencies aren’t always positive, however. If inflation rises and is greater than nominal interest rates, real rates turn negative. This is when you want to own gold. We view gold as a currency without the ability to earn any yield. When other currencies, like the US dollar, have negative real yields, gold looks a whole lot more attractive. When short-term US real yields are negative, the Fed is essentially eroding the purchasing power of the dollar and alternatives like gold become more attractive.
With debt expected to keep expanding, real rates are likely to stay negative for a long time or even fall further into negative territory. How can they not? From this perspective, more debt means a higher gold price. CrossBorder Capital, in fact, has studied the level of US debt priced in gold terms over the past 100 years and found it has averaged 30 million ounces. Based on where US debt is now, gold could rise by about 40%. It’s no wonder central banks are looking to hold more gold and perhaps less US dollars. For investors, however, the role gold plays in a portfolio is one of diversification and insurance. Gold shines when other assets do not. Its short-term performance is not as important as the role it plays in protecting wealth in certain negative scenarios. You don’t need a repeat of the Weimar Republic for gold to do well, but negative real rates are essential.
Where does the US dollar’s reserve currency status stand?
As the US dollar is the World’s reserve currency, it is considered to be the ultimate safe-haven asset. But when you don’t trust the value of the greenback, gold becomes the go-to safe haven of choice. Some believe the recent decline of the US dollar and the rise of gold is a sign that the dollar’s reserve currency status is being questioned. Ray Dalio, head of the world’s largest hedge fund in the world, Bridgewater, has recently researched the path of previous reserve currencies, like the Dutch Guilder and British Pound, in order to gain insight into what may lie ahead for the US dollar.
While the timing is still uncertain, the progression of combining fiscal policy with monetary policy follows the script, as does the emergence of a global competitor in China. Goldman Sachs has also recently argued the US dollar’s reserve currency status is coming under increased scrutiny as increasing debt levels and financial repression continued to chip away at the dollar’s appeal. With the dollar hitting its lowest level in two years in July, Goldman’s concerns over the dollar are gaining traction, with many blaming the Federal Reserve.
While it is certainly possible the US dollar loses its reserve currency status at some point in the future, we don’t think that is why the greenback has been weakening. Rather than growing debt levels spooking global capital flows, we suspect the poor response to the pandemic and slower economic growth in the US versus Europe and Asia is the main cause for the decline, which we view as short-term. Also, the US dollar typically trades as a countercyclical currency meaning better global growth should see the dollar weaken. We are worried about the path of higher debt levels being facilitated with easy monetary policy and inflation, but we see this as a global issue not confined to just the US.
Most cross border trade is still conducted in dollars and the greenback maintains a dominant position when it comes to foreign currency reserves. As a potential hedge, however, we would look to diversify our political and geopolitical exposure by continuing to evaluate emerging market debt and equities, including that of China. If the US and Chinese economies do decouple, Chinese government debt could be a very important diversifier for investment portfolios, assuming one can get past the lack of transparency, absence of rule of law, and capital controls to name a few. All things being considered, we still don’t see an alternative to the dollar as the world’s reserve currency and view it as the “least dirty shirt,” other than gold of course.
Forecasting in this environment, both direction and timing is particularly hard given choices made by governments will play a large role in the future direction of deficits, inflation, and interest rates. While it is possible the pre-pandemic status quo of lower interest rates, gradually rising debt levels, and slow but positive economic growth could be maintained for the foreseeable future, we believe investors need to consider the role politics will play in addressing the growing wealth gap and other imbalances in today’s society and economies.
In this environment, we see debt levels being driven even higher, with inflation eventually following. With central banks keeping nominal rates in check, however, higher inflation will result in lower real interest rates. Higher real rates would be catastrophic in a world of rising debt levels. We see it as the central bank’s job to make sure real rates stay low, or even negative, as inflation erodes purchasing power and the value of debt. This is actually not a bad environment for equities (both public and private) as future profits and cash flows are discounted at lower real interest rates. The same goes for real estate and infrastructure, which many sovereign funds are allocating more assets towards. The key, of course, is to make sure the assets you hold are able to maintain their cash flows, either corporate earnings or lease payments. It’s also an ideal environment for gold.
Lower real interest rates and higher debt levels will increase the demand for gold. Eventually, however, pressure on real rates and inflation will be too much for the Fed and other central banks to contain and nominal rates will start moving higher, perhaps much higher. This is a bad environment for all investments, including gold eventually. Once inflation becomes a bigger threat than economic growth, the Fed will have to increase rates above the rate of inflation, thus driving real rates higher. This is what ended the gold rally of the 1970s. When this happens, it’s time to shift back into government bonds. Up until then, however, Treasury Bonds will be a tough place to make money, providing what James Grant has referred to as “returnless risk”. Credit (both public and private) and select sovereign risk assets will be the major sources of fixed income return in the future as opposed to the duration or term risk as nominal rates inevitably move higher.
Timing is going to be tough. Markets can take years to transition, or they can shift overnight. A diversified portfolio is the best protection against the uncertainty that lies ahead. Returns are also likely to be choppy especially given current valuations for risk assets are high. In the short-term, we view the direction of the market as a bit of a coin toss, dependent upon how quickly we get a vaccine and the degree fiscal policy can mitigate the economic damage from the pandemic. Years from now, historians will likely still be debating how asset prices were able to recover with such veracity given the lockdowns and their impact on the economy. What comes next could be even more historic.
Nicola Wealth Portfolio – Investment Returns
Returns for the Nicola Core Portfolio Fund were +2.0% in the month of July. 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 1.9% in July. Spreads continue to narrow led by Energy, Telecom, and Financials while Real Estate lagged. The market has now retraced 80% of the widening in spreads seen in March. We think in the short-term, Government Yields are likely anchored at the lower-end. With an estimated deficit of $343 billion for FY20/21 and with the intention for the government to borrow significantly more than usual in longer maturities, we believe that there is the potential for a steeper yield curve in the mid to long term. In addition, recently Fitch Ratings downgraded Canada’s sovereign rating from AAA to AA(high). Often times other rating agencies follow the lead of each other. A downgrade from another rating agency may cause investors to re-evaluate their AA positions and cause downward pressure on Canadian, provincial, and highly rated corporate bonds, leading to the potential for higher rates.
The Nicola High Yield Bond Fund returned +1.9% in July. The market continues to march higher off of a technical tailwind. Investors sitting on the sidelines with cash have caused reacceleration in retail flows into high-yield creating higher demand. Overall, we remain cautious on the market as there are a number of large investment-grade companies that could have their ratings downgraded to BB (non-investment grade). Additionally, August historically tends to be a more volatile month for high-yield, mounting concerns in the US on a potential change in political regimes coupled with a rise in defaults could cause a sell-off particularly in the technology and telecom sector where spreads are relatively tight.
The Nicola Global Bond Fund was up 0.4% for the month. Last month, we allocated capital to the US Federal Reserve’s Term Asset-Backed Loan Facility (TALF) which allows select investors to borrow directly from the Federal Reserve to invest in eligible securities (commercial mortgage-backed securities, private student loans, credit cards, auto loans/leases, etc.). We exited our position in the Manulife Strategic Income Fund to participate in the TALF opportunity. As central banks have suppressed volatility, it has become more difficult to maintain a resilient portfolio. We believe that the TALF opportunity gives the Nicola Global Bond Fund the ability to invest in high-quality assets with a strong return profile if a more adverse economic environment were to emerge. Typically during a recession, debt levels decrease as highly-levered companies go bankrupt. As there have been fewer bankruptcies this year coupled with high net issuance, we have seen corporate debt levels rise overall. Despite higher corporate leverage, US household debt remains comparatively low. We believe that by focusing on structured products such as in the TALF program, we can benefit from the strength of low homeowner leverage to provide stable returns if growth disappoints in the future.
The returns for the Nicola Primary Mortgage Fund and Nicola Balanced Mortgage Fund were +0.4% and 0.5% respectively in July. Cash liquidity in both funds is elevated but remains within historical norms. The economic impacts of COVID-19 have affected four loans in the Nicola Primary Mortgage Fund and four loans in Nicola Balanced Mortgage Fund, unchanged since May. We continue to review new loan opportunities with our first funding since March scheduled for August. 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 are in no way is a predictor of future performance, are 4.0% for the Nicola Primary Mortgage Fund and 5.6% for the Nicola Balanced Mortgage Fund. The Nicola Primary Mortgage Fund had 16.3% cash at month-end, while the Nicola Balanced Mortgage Fund had 14.1%.
The Nicola Preferred Share Fund returned +7.0% for the month while the BMO Laddered Preferred Share Index ETF returned 7.7%. The strength of the preferred share market came off of a new RBC note that has changed the landscape for preferred shares. Banks issue preferred shares as part of their regulatory requirements for bail-in assets. During the Great Financial Crisis, banks were bailed out by the government. In order to mitigate risk-taking and reliance on the government, regulators forced banks to have capital that can convert to equities if banks face going concerns, hence bail-in. Until recently, there have been limited options for banks for these types of bail-in assets. Banks have been forced to issue preferred shares at expensive rates, particularly as the market participants are retail investors who have soured on the asset class. The new RBC note effectively takes the same place as preferred shares for a bank’s capital structure but it was structured for institutional investors and is tax-favourable for the banks. The note was issued at 4.5% (a 414 basis point spread over Government of Canada). Immediately, bank preferred shares re-priced to comparable levels. We believe that other banks and insurance companies will issue this new type of note which will be cheaper than preferred shares. As a result, we believe the preferred market will re-price higher over the next few quarters. At the same time as preferred shares get redeemed, the market may shrink drastically over the next few years and eventually, may not be an attractive long term asset class.
The S&P/TSX was up +4.5% while the Nicola Canadian Equity Income Fund was +4.1%. All of the TSX sectors were strong in the month but the largest positive contributing sectors to Index returns in July were Materials and Industrials. The underperformance of the Nicola Canadian Equity Income Fund was mainly due to being underweight in Technology where Shopify has driven returns. The top positive contributors to the performance of the Nicola Canadian Equity Income Fund were Kirkland Lake Gold, Interfor, and Canwel Building Materials. The largest detractors were Brookfield Business Partners, Air Canada, and Minto Apartment REIT. In July we added a new position: Brookfield Renewable Partners LP. There were no deletions in the month.
The S&P/TSX was up +4.5% while the Nicola Canadian Tactical High Income Fund underperformed with a return of +3.7%. All of the TSX sectors showed positive performance in July. The Nicola Canadian Tactical High Income Fund benefited from strong performance in Communications Services, Consumer Discretionary and Utilities offset by being underweight Industrials and Technology. The Nicola Canadian Tactical High Income Fund has a Delta-adjusted equity exposure of 79% and the projected cash flow yield on the portfolio is over 9%. In the month, we reduced our exposure to the Consumer Discretionary sector and sold positions in Dollarama and Magna International. We added a new Technology name in Kinaxis.
The Nicola U.S. Equity Income Fund returned +5.2% vs +5.6% for the S&P 500. The Nicola US Equity Income Fund’s positive performance was driven by select stocks that benefited from the stay-at-home theme such as Amazon within Consumer Discretionary (huge beat in operating income $5.8B vs low guidance and street estimates), Walmart, Proctor & Gamble and Costco within the Consumer Staples sector and companies such as Electronic Arts (video games), Verizon and Comcast in the communications sector. The benchmark’s strong return was primarily driven by Information Technology (IT) (27.5% weight vs the Fund at 12.6%) and consumer discretionary (i.e. Amazon is close to a 47% weight in the sector). The Nicola U.S. Equity Income Fund took advantage of relatively high volatility and valuations by writing 10 covered-calls. Most of the names written were in the IT sector. The Nicola U.S. Equity Income Fund ended the month 11.5% covered. Delta-adjusted equity exposure is 93.3%. The current annualized cash flow is 5.1%. During the month, no new names but we added to our existing positions and trimmed back our holdings in Amazon and Disney due to valuation and cloudy outlook for Disney.
The Nicola U.S. Tactical High Income Fund returned +2.9% vs +5.6% for the S&P 500. The Fund lagged the benchmark due to being underweight certain stocks (i.e. Amazon) and sectors (Healthcare and Information Technology) relative to the benchmark. July saw large swings in option writing from the prior month. Last month, we wrote 22 put-options ($51MM notional amount) vs only five puts ($11MM notional) in June. On the call-option side, we sold 12 call-options in July vs 48 call-options in June. Option writing continues to provide double-digit annualized premium yields with attractive upside/downside break-evens. The Nicola U.S. Tactical High Income Fund ended the month having 86% of long positions covered and delta-adjusted equity exposure of 56%. Portfolio activity: we added to some higher-yielding names in Energy and IT (Valero Energy & Seagate Technologies) while selling names where company fundamentals look weak (Molson Coors and Delta Airlines).
The Nicola Global Equity Fund returned +2.3% vs +3.8% for the MSCI ACWI Index (all in CDN$). The Nicola Global Equity Fund underperformed the benchmark due to being overweight in Japan & Developed Europe while being underweight in the US. From a sector level, the Nicola Global Equity Fund benefited from being underweight in Energy and overweight in Consumer Staples; however, the Nicola Global Equity Fund’s relative underweight in Information Technology and overweight in Industrials detracted from performance. During the month, we initiated a new position in a dedicated Emerging Markets Fund (JP Morgan Global Emerging Markets Fund) which expands on our existing emerging markets exposure. Our Emerging Markets managers and Large-Cap growth managers lead the returns last month. Performance of our managers in descending order was BMO Asian Growth & Income +4.7%, Pier 21 Worldwide Equity +4.5%, JP Morgan Global Emerging Markets +2.6%, Pier21 Global Value +2.5%, Lazard Global Small-cap +1.4%, NWM EAFE Quant Fund +1% and Edgepoint Global Portfolio +0.2%.
The Nicola Global Real Estate Fund return was -1.1% in July vs. the iShares S&P/TSX Capped REIT Index (XRE) +1.2%. Currency was a headwind as the C$ was relatively strong in June and over 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 volatility for the REIT complex will 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. Longer-term we like the risk/reward setup for publicly-traded REITs and view valuations as very attractive. We continue to favour the Industrial and Multi-family sectors and are overweight in those areas in the portfolio. We added Granite REIT to the portfolio in July. There were no sells.
The Nicola Sustainable Innovation Fund returned +10.1% (USD)/ +8.6% (CAD) in July and has returned +13.8% (USD)/ +17.4% (CAD) year-to-date. The strong performance this month was buoyed by the surge in polling of Democratic presidential candidate and former Vice President Joe Biden and his proposal for a $2-Trillion Climate Plan which would see many of the portfolio’s companies as beneficiaries of increased investment into clean energy infrastructure projects. Two additional names were added to the portfolio this month: the US residential solar and energy services leader Sunrun Inc. and Ormat Technologies, a global provider of geothermal power and equipment. Sunrun Inc., Hannon Armstrong, and Vestas Wind Systems were the top contributors to performance while Ormat Technologies, Ameresco Inc., and Aptiv PLC were slight detractors to performance. In addition to the new names added, during the month we topped up a number of existing positions including NextEra Energy, Iberdrola, Northland Power, Orsted, and Itron.
The Nicola Alternative Strategies Fund returned 1.5% in July. Currency detracted -0.9% to returns as the Canadian dollar continued to rebound and strengthen through the month. In local currency terms since the funds were last priced, Winton returned -2.6%, Millennium +1.5%, Renaissance Institutional Diversified Global Equities Fund +0.5%, Bridgewater Pure Alpha Major Markets +1.8%, Verition International Multi-Strategy Fund Ltd +4.3%, RPIA Debt Opportunities +4.7%, and Polar Multi-Strategy Fund +4.7%. Year-to-date, the multi-strategy arbitrage funds (Verition and Polar) have performed well. The diversified nature of their niche uncorrelated strategies coupled with active trading and dynamic capital allocation has allowed them to benefit from the increased volatility without suffering the same drawdowns as the equity or credit markets. Verition has increased allocation to credit strategies to approximately 25% including a fixed income ETF arbitrage strategy. With the proliferation of ETFs, large swings in ETF pricing do not always reflect the changes in the pricing of the underlying assets. Verition aims to take advantage of the difference between the price of ETFs and the underlying assets without taking market exposure. Strategies such as ETF arbitrage not only have limited exposure to market risk but should benefit if markets sell-off and create more pricing discrepancies in the future.
The Nicola Precious Metals Fund returned +15.2% for the month while underlying gold stocks in the S&P/TSX Composite Index returned +14.8% and gold bullion was up 9.6% in Canadian dollar terms. It would not be unusual to see some pullback after such a strong month; however, we remain constructive on gold as valuations remain attractive. Unlike previous cycles, the sector has shown more discipline in terms of cost controls and the average Canadian investor remains significantly underweight gold relative to the Index. In addition, historically, gold has performed well as debt/GDP rises and during periods of low or negative real rates.
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.