Market Commentary: The Markets Still Have Room to Run - Nicola Wealth

Market Commentary: The Markets Still Have Room to Run


By Rob Edel, CFA

 

Highlights this Month

 

December In Review 

Markets finished the year on a strong note, with most asset classes ending 2020 solidly in the black, and most global equity markets recovering from their pandemic induced lows, and then some. From an asset mix perspective, stocks again led the way, but declining interest rates helped fixed income deliver an admirable performance. Commodities trailed both and ended the year in the red, but not for a lack of trying, rallying strongly into the new year.

In equity markets, performance by country mirrored progress made in battling the pandemic, with Asian markets turning in the best returns, while Europe lagged. The US could be an outlier in this regard, with relatively good equity returns, despite challenging results containing the pandemic. Before turning the page on 2020, we are going to look a little closer at market performance last year in order to gain some insight into what to expect in 2021.

Overall, we are relatively bullish on returns for risk assets, despite some segments of the markets displaying some irrational exuberance. Low-interest rates form the basis for our belief markets can continue to move higher in 2021, so we plan to keep a close eye on both bond yields and inflation as potential early indicators for a shift in sentiment. Of course, the pandemic and politics will continue to weigh on investor’s minds and could impact the returns, but our base case remains the positive support from the fiscal and monetary policy will keep investors safe in 2021.

Big cap Technology and Consumer Discretionary companies were the big winners.

While overall index returns in the US were very strong, not all sectors and stocks participated evenly. The S&P 500 was up 16.5% (all returns are total returns in Canadian dollar terms), but when equally weighted (the S&P 500 is weighted by market capitalization), the increase in the S&P 500 was only 11.0%. Big cap Technology and Consumer Discretionary companies were the big winners, while energy (oil and gas) sustained losses and lagged far behind.

In December, performance was much more evenly distributed, with the S&P 500 gaining 2.2%, but +2.6% on an equal weight basis. In Canada, sector leadership was very similar, but because the technology sector is much smaller and the energy sector much larger, the S&P/TSX trailed the S&P 500 in 2020, increasing only 5.6%. Like in the US, however, returns were more evenly distributed in December, with the S&P/TSX up 1.7% and many more cyclical sectors like energy starting to close the gap and continuing to rally into early January. Increased market breadth is a positive sign, especially when more cyclically oriented companies participate. It is typically a sign of confidence in the future health of the economy.

Fixed income markets moved in a bullish direction.

It was not just in equities returns where confidence in the economy was exhibited, fixed income markets were also moving in a bullish direction. After Treasury yields and credit spreads soared in March, driving prices materially lower, fixed income markets followed the equity markets in steadily recovering as the year progressed. Treasury yields moved the quickest, followed by investment grade, with more risky non-investment grade gradually following suit. Treasury yields and investment-grade credit spreads, in fact, ended the year lower than they were at the end of 2019, with companies able to issue long-term debt at rock bottom yields.

Our market forecast for 2021.

In looking forward to what we think might happen to markets in 2021, we fully acknowledge to exhibiting a fair bit of hubris in even attempting a forecast. Akin to predicting the weather (though we suspect the science of predicting the weather has improved greatly over the years), forecasting the market is tough, with many factors (many unforeseen) having a potential impact. Who, for example, at the beginning of 2020 would have seen oil trading below zero during the year and the Nasdaq up over 67% (US $ terms) during one of the sharpest recessions in history?

We won’t even go into the events surrounding the US election. Suffice it to say, at the beginning of the year President Trump was considered a shoe-in to be re-elected. According to a recent New York Times article, Wall Street was consistently wrong in forecasting the market last year. In December 2019, the average forecast for the S&P 500 in 2020 was a mere +2.7%. When the pandemic hit, an April Bloomberg survey showed forecasters had lowered their forecasts to an 11% loss. The S&P 500 ended the year up over 18%. Enough said.

Since 2000, in fact, the median forecast by Wall Street Analysts has never predicted a decline, despite the fact the market has gone on to fall nearly a third of the time. A similar pattern can be found in forecasting bond returns, with forecasters consistently believing rates would rise. Timing can be crucial when it comes to the market, and selling at the wrong time can be costly. According to Strategas, over the past 25 years investors who remain fully invested earned a compound annual return of 8.3%. Miss the five highest returning days, however, and your return drops to 6.4%. Absent for the market’s 50 best days and you would have lost 1.9% a year.

No wonder most Wall Street analysts never forecast a losing year for the market. Being out of the market at the wrong time can be a career mistake. That and the fact it’s not that profitable to tell customers to avoid the market when you are in the business of selling stocks. What is Wall Street forecasting for 2021? I think you already know the answer. While one would be justified in being a little cynical, we agree with this bullish call for 2021, and here is why.

With strong 2020 results, can a correction in 2021 be expected?

It would be a mistake to assume that because the market was so strong last year, a correction in 2021 can be expected. According to Goldman Sachs, since 1928 the S&P 500 has increased 66% of the time. Strategas points out historically after markets have experienced strong nine-month rally’s off a bottom, the next nine months have seen an average 8.1% return. No matter that the following nine months produced an average 9.7% decline, we are focusing on 2021 here!

We will worry about 2022 later. Also, Strategas highlights how a strong quarterly return in the small cap Russell 2000 index is usually followed by another two strong quarters. In Q4, the Russell 200 gained 31.4% (in US dollar terms).

In looking at historical patterns, Strategas has also drawn attention to how similar the current rally is to previous rallies off bear market lows in 1982/3 and 2009/10. In both cases, the initial nine-month 60% rally was followed by a trading range lasting (roughly) 12 months, after which stocks continued to rally.

Strategas also observed last year the S&P 500 traded below the previous year’s (2019) low, and then went on to close the year above the 2019 high. This has happened only twice since 1950, in 1982 and 2016, and the S&P 500 was up the following year 17% and 19% respectively. Some fear, however, the most relevant historical pattern to watch is the market top in 2000 and the bursting of the dot com tech bubble.

Fortunately, as noted value investor Jeremy Grantham recently pointed out, investors in both the 2000 and 2010 bear markets were given ample opportunity to exit before the market reached its lows. More optimistically, the roaring 1920’s is cited as a valid comparable, given it followed the 1918 Spanish Flu pandemic and was characterized by a period of unabashed consumption and economic growth. We would point out that it also followed the First World War, which might have played a larger role in unleashing pent up demand and growth. Regardless, most of the gains in the Dow Jones Industrial Index in the 1920’s didn’t take place until the second half of the decade, and it didn’t end well.

Possible factors with the potential to derail markets this year.

When we look at possible factors with the potential to derail markets in 2021, a dot com like asset bubble does hit the radar screen as there were several examples of a frothy market to choose from last year. According to Dow Jones Market Data analysis of Factset data, more stocks posted gains of over 400% than in any year since 2002.

Options Clearing Corp reported option volume hit their highest levels on record, and retail investor participation skyrocketed, with JMP Securities estimating a record 10 million new brokerage accounts were opened in 2020 and daily visits to online trading sites soared. Perhaps most troubling, margin debt increased, and more than $14 billion flowed into risky leveraged and inverse ETF funds, the most since 2008. Animal spirits were raging, and retail investors are both an indicator of the degree to which bullish sentiment is building. Historically, the story hasn’t ended well for retail investors chasing returns.

Institutional money managers are also concerned about the price action in certain parts of the market. According to a Bank of America Fund Manager survey in December, 52% highlighted technology stocks as the market’s most crowded trade, while a similar RBC poll found 83% thought action in the SPAC Market (Special Purpose Acquisition Company) was a sign of a frothy market.

Why is Tesla one of the most heavily debated stocks on Wall Street?

While it’s officially classified as a consumer discretionary stock and is not in the technology sector, Telsa is perhaps one of the most heavily debated stocks on Wall Street when the subject of asset bubbles comes up, with some believing its valuation is absurd, while others are convinced it has room to move much higher.

Last year Tesla’s stock price gained a remarkable 743%. What makes this move even more remarkable was there was no material change in the outlook for Tesla in 2020. Earning estimates, in fact, haven’t changed in two years and sales actually slightly missed management’s 500,000 car target in 2020. Despite this, investors value Tesla more than the next eight largest car manufacturers combined.

In November, S&P Dow Jones Indices announced plans to add Tesla to the S&P 500, the most widely followed US Stock benchmark. Tesla was the largest company to ever join the S&P 500, and upon confirmation of its addition, Tesla’s stock price rallied another 73% before year-end. Tesla is now the sixth-largest company in the index, despite making virtually no money. We would classify this as frothy.

The red hot SPAC and Initial Public Offering market.

Another red flag-raising eyebrows have been the red hot SPAC and IPO (Initial Public Offering) market. According to Bloomberg, nearly 500 companies went public last year, raising a record $177 billion, and $78 billion were SPAC’s, a total exceeding the combined total of money raised by SPAC’s in all previous years. A SPAC is essentially a blank cheque IPO, where a company is formed with the intention of acquiring or merging with another company, usually private, within a stipulated period of time, typically two years. Once the SPAC’s management team identifies the target, investors can either agree to the transaction or ask for their money back, with interest. SPAC investors are typically also granted warrants as a further incentive to buy the IPO. While this may appear to be a good deal, it pales in comparison to the deal the SPAC’s originators and management team typically work out for themselves in the form of founders shares, which typically total 20%-25% of the SPAC’s total value, which vest once an acquisition is consummated.

US academics Michael Klausner and Michael Ohlrogge estimate between the cash drained away by the IPO buyers exercising their option to have their capital returned, with interest, and management’s 20% to 25% promote, only 50% of the IPO cash raised actually finds it’s way to the target company. While this might not appear very appealing for those investors looking to buy in, it hasn’t hurt the stock price of these blank cheque companies as they continued to move higher last year. Same for many traditional IPO companies, including high-profile debutants Airbnb and Doordash, with Airbnb more than doubling and Dooordash up 82% on the first day of trading after their public market listings in December.

According to University of Florida Professor Jay Ritter, the average first-day return for operating company IPOs in 2020 was 41%. As for SPAC’s, from the beginning of July until the end of the year, the IPOx SPAX index gained over 48%. A lot of faith for companies with only a promise and a blank cheque.

Is the market getting dangerously overheated?

So definitely some signs of froth, but what about the market overall? This is what we are really worried about. Is the market getting dangerously overheated? With most indices hitting new all-time highs and valuations back to levels last seen during the 2000 tech bubble, there is growing concern the market is pricing in a lot of good news, and then some. Price to sales multiples for the S&P 500 is at record levels, as is price to earnings multiples, even when using earning forecasts over two years. The S&P 500 CAPE (Cyclically Adjusted Price Earnings) Shiller P/E multiple is regarded by some as the gold standard for valuing big-cap stocks because it uses a 10 year rolling average of earnings, adjusted for inflation. While the S&P 500 CAPE P/E ratio hasn’t yet reached levels hit during the dot com bubble, it is at similar levels that existed prior to the 1929 stock market crash.

Perhaps just as troubling, the level of the CAPE Shiller P/E has historically been a good predictor of future returns, with higher CAPE Shiller P/E’s being strongly correlated with lower returns over the following decade. Based on a current P/E of over 30, returns over the next 10 years should be negative. That’s the bad news. The good news is there is a very weak correlation between PE multiples and stock market returns in the short term. Remember? We are only concerned with 2021 returns right now. We’ll worry about the rest of the decade later.

The correlation is more meaningful in the long term, but over the next year or two, valuations do not have much predictive power for returns. Also, while valuations are very high in absolute terms, compared to bonds, equity values actually look pretty good. According to the S&P 500’s relative earning yield, which is its forward earnings yield (the inverse of the P/E multiple) as a ratio of the US 10 year Treasury yield, equity valuations are much more attractive compared to historical averages. The higher the ratio, the cheaper the market, and according to CIBC World Markets the average relative earnings yield historically has been 2.55 times versus 4.72 currently. Even Robert Shiller, the creator of the CAPE Shiller S&P 500, has recently revised his index to take low-interest rates into account. By taking the inverse of the CAPE (earning over price) minus the 10 year Treasury yield, Shiller derives what he refers to as the “Excess CAPE Yield”. The higher the ECY, the greater the odds stocks will outperform bonds in the future, even if their normal CAPE P/E is historically very high. According to a recent article in the Financial Times, the current ECY is 4%, which should translate to a 5% annualized real return over the next decade, hardly what fortunes are made from, but better than a negative return.

What happens when bond yields start to rise?

While it is comforting to know stocks are not expensive compared to bonds, it begs the question, what happens if, or probably more accurately, when, bond yields start to rise? We don’t worry about short term rates. The Federal Reserve has assured the market they won’t be raising rates any time soon so the short end of the yield curve is likely anchored at zero for the foreseeable future.

It’s longer-term yields that have our attention, probably 5 years and longer. According to a poll conducted by RBC Capital Markets in December, 90% of institutional investors don’t see 10-year yields exceeding 1.5% by the end of 2021. Point of reference, they ended 2020 at 0.91%. According to a December 16th survey conducted by Strategas, a majority of investors don’t see higher 10-year yields becoming a concern until 10-year yields move above 3%. In fact, raising rates can actually be good for equity returns given rates typically rise because the economy is getting stronger. According to a recent CIBC World Markets report, the S&P 500 has increased an average 17.9% during past notable periods of rising rates.

So markets can deal with higher rates, it’s more a question of how much and how quickly rates go up. If rates go up too much too quickly, the market will eventually correct. Historically higher inflation is the main culprit behind such a move and given recent history, rising prices don’t appear to be a problem.

Inflation has struggled to even hit the Federal Reserve’s 2% target over the past decade, let alone exceed it. More to the point, we are still officially in a recession, and recessions are typically deflationary events, not inflationary, and with the GDP output gap still well below capacity, it’s hard to make the argument that inflationary pressures are poised to re-emerge.

And yet that is exactly what many investors are doing. According to a Strategas, 77% of Institutional investors are more concerned about inflation than deflation, while RBC reports 59% believe inflation will accelerate over the next 6 to 12 months. Financial markets appear to agree, with breakeven rates (inflation rate required to be indifferent between owning inflation-protected bonds, or TIPs, and normal Treasury Bonds) on 10-year inflation-protected notes spiking to 2% at the end of 2020. Now to be fair, 2% is only marginally higher than where breakeven rates were before the pandemic, but the rally in breakeven rates looks to be gaining speed. It’s one of the key variables we plan to watch in 2021. Higher inflation and the resulting increase in yields is like kryptonite for stock valuations.

A demand induced jump in inflation is what many forecasters are watching.

What many forecasters have their eye on is a demand-induced jump in inflation once the pandemic is over and social distancing measures can be relaxed or even eliminated. Consumers not only have the desire to spend but the money as well.

According to the Bureau of Economic Analysis, suppressed consumption, low-interest rates, and government handouts have left US households with about $1.4 trillion more in their bank accounts than if there had been no pandemic. This doesn’t necessarily mean it will all be spent, however. Sure, we are all looking forward to going out for a meal, or maybe even taking a trip, but to what degree? According to a YouGov survey, when asked what they would do with an unexpected windfall, most Americans said they would either save it or use it to repay debts. According to Nanos Research Group, the top financial priority for 76% of Canadians polled was either paying down debt or saving extra money, versus only 11% who were eyeing a major purchase.

Of course, sentiment might change in a post-pandemic world when we are finally able to remove our masks, but concerns over higher future taxes and lower interest rates hurting future investment returns might motivate consumers to save more than they did before the pandemic. This might not be a bad thing. If demand is too strong and inflation moves higher, markets could sell-off, especially if the Federal Reserve is pressured to tighten monetary policy. We don’t think they would raise rates, but a quicker tapering of the monthly $120 billion per month bond-buying program (aka quantitative easing) would certainly be up for discussion.

Economic uncertainty is another reason consumers could stay on the sidelines.

While GDP growth last year ended up being much better than forecast earlier in the year, falling mobility due to increased lockdown measures has slowed the recovery’s progress recently. December, in fact, saw the first decline in employment since April. Not surprisingly, while forecasts for GDP growth in 2021 and 2022 show the economy continuing to recover, the range of the forecasts remain fairly wide. There are just too many unknowns surrounding when the pandemic will actually end, and what its longer-term legacy will be.

The effect of US election politics on the economy.

One uncertainty we thought had already been resolved was who was going to occupy the White House for the next four years. While President Trump’s refusal to admit defeat has certainly been a distraction for the Nation, it was largely a non-event for the markets. Even on the day Trump supporters stormed the Capital Building, in what will likely go down as one of the darkest days in US history, the markets went up, with call option trading volume hitting its fourth-largest level on record.

Rather than worry about the fate of democracy, markets were optimistically looking at the outcome of the Georgia Senate runoff elections which saw the Democrats win both seats and thus take control of the Senate. Optimistically, markets now see more fiscal stimulus, in addition to the $900 billion agreed to at the last moment in December, which will be good for economic growth, but without the downside of higher taxes.

Too much stimulus might be bad for markets if it risks creating inflation, but for now, markets appear convinced it won’t be an issue. With the slimmest control of Congress in 60 years, the market hopes Biden and the Democratic party will be limited in advancing a more progressive and ambitious agenda, like raising taxes for corporations and the wealthy. As for Trump, before “Insurrection Day” he was still viewed as the Republican party favourite in 2024, but the Donald may have finally gone too far.

Hopefully, the easy media opportunity days are drawing to a close for Trump, and we hope he fades into obscurity after Joe Biden becomes President on January 20th. ON the other hand, Trump’s hold over his supporters can’t be discounted, and more civil unrest is possible. Regardless, it’s not something the market is focused on, right now anyway.

The markets are not concerned about the pandemic.

To some degree, we would say the same about the pandemic. As expected, infection rates are accelerating, and a new more infectious mutation is threatening to make the situation even worse. The risk the health care system becomes overwhelmed is becoming a very real possibility and will likely lead to even more severe lockdowns, which appears to be the only real defence in the short term. But the markets don’t care.

While tragic from a human perspective, and economic in the short term, only if a material issue with either the distribution or efficacy of the vaccines emerges do we believe markets will be impacted. So far, while the vaccine rollout has been slower than expected, particularly in Canada, it hasn’t been material enough to impact markets. As for the efficacy of the vaccines, while the mutations appear to make COVID-19 more infectious, the vaccines are believed to still be effective. If this turns out not to be true, markets would re-price, even with more fiscal stimulus.

When we look back at 2020, we still find it hard to believe markets did as well as they did given the pandemic and its impact on the economy. It may have been a bear market for humans, but not for stocks, or at least not for long.

It was the speed and magnitude in which fiscal and monetary policy was deployed that turned markets around. Low-interest rates and liquidity helped support valuations, while fiscal stimulus supported businesses and households.

Looking forward to 2021, what could go wrong?

Sentiment is getting a little stretched and some asset bubbles are forming, but the broader market still has room to run. We could see a pullback or consolidation in the short term, but not a major correction. As long as interest rates stay low and monetary conditions easy, markets should stay out of trouble.

Higher inflation remains the key risk in this regard. While we are less concerned about a longer-term secular increase in inflation starting this year (more likely 2 to 3 years down the road), the unleashing of pent-up demand after the pandemic could cause inflation to spike higher in the short term. Markets would use this as an opportunity to challenge the Fed’s resolve in keeping interest rates low and letting the economy run hotter. While this is a risk, we would see this as a buying opportunity for more patient investors.

We believe the economy will experience reflation rather than sustained inflation, and that is good for the economy, and good for markets. Too much fiscal support from the new Democratic Administration could also present a longer-term risk, but in the short term, its impact will fall more under the reflation than inflation category. The pandemic will remain a focus, but it would take a material setback on the vaccine front to alter our bullish outlook for markets in 2021. Based on market action from last year, it appears as long as the prospects for the vaccine remains bright, it doesn’t matter how dark the tunnel might get in the short term.

 

Nicola Wealth Portfolio Results

Returns for the Nicola Core Portfolio Fund were +1.5% in the month of December. 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 0.7% in December. The December Santa Claus rally in credit markets meant that we ended the year at or near low spreads for the year. The tightening of spreads benefitted East Coast (one of our external managers) which returned 1.9% for the month.

Our positions in safe yield to call preferred shares also helped contribute to returns and were up 0.5% for the month. Given credit spreads are at their lows, we are cautious in the near term based on valuations, although any credit spread widening is likely to be muted. Central banks will continue to support markets and 2020 set a new issuance record as companies raised significant amounts of cash, both de-risking further funding concerns and reducing the potential of significant supply in 2021. The demand for yield should persist in 2021 as North American credit markets still look attractive on a relative basis to foreign investors, and domestically many investors have parked money in the money market and will likely start to deploy those assets in bond funds.

The Nicola High Yield Bond Fund returned 0.4% in December. Currency detracted 1.2% as the US dollar weakened versus the Canadian dollar. Spreads closed the year at similar levels to where they started the year, although because government bond yields moved significantly lower, high yield bond yields are at all-time lows.

We continue to see the most value in the safer BB portion of the high yield market. Potential defaults in 2021 are our largest concern and thus we are likely to have underweight positions in riskier portions of the market until more attractive opportunities present themselves. We will also continue to look for unique opportunities and leverage our relationships, such as with our recent allocation to the Pimco Tactical Income Fund. Since we invested in the IPO in late October, the investment is up 8%, almost double the high yield market, which was up 4.4% during the same period.

The Nicola Global Bond Fund was up 0.4% for the month. Pimco Monthly Income had a strong month, benefitting from credit spreads tightening and returned +1.5% in local currency terms. Our exposure to securitized assets also contributed materially to returns as the BlackRock Securitized Investors fund returned +2.8% in local currency terms. Overall, we have maintained a low duration in the Nicola Global Bond Fund. The Fed will maintain interest rates at current levels “until labour market conditions have reached levels consistent with maximum employment and inflation has risen to 2.0% and is on track to moderately exceed 2.0% for some time”. This implies that the Fed is willing to allow the US economy to run hot in upcoming years. We expect longer-term yields to move higher and the yield curve to steepen and will underweight exposure to the long end of the yield curve.

Returns were 0.4% for Nicola Primary Mortgage Fund and 0.5% for the Nicola Balanced Mortgage Fund in December, with annual returns for 2020 of 3.2% and 5.1% respectively. December was a strong month for new loans funded in both funds, which along with net redemptions related to waitlist draws from other funds resulted in cash levels decreasing to 4.5% in the Nicola Primary Mortgage Fund and 17.2% in the Nicola Balanced Mortgage Fund at the end of December. Current annual yields, which are what the Nicola Primary Mortgage Fund and the Nicola Balanced 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 4.2% for the Nicola Primary Mortgage Fund and 5.4% for the Nicola Balanced Mortgage Fund.

The Nicola Preferred Share Fund returned +3.7% for the month while the Laddered Preferred Share Index returned +3.5%. Overall, markets moving higher helped support preferred shares which participated in the rally. We end the year with less supply in the marketplace as $2.45B of preferred shares were called while only $650 million was issued. Non-financials have played a larger role in the preferred share rally as Brookfield, Artis REIT, Atlantic Power, and BCE all announced buybacks for shares. We continue to be constructive in Artis REIT where the activist investor calling for change at the firm has now been appointed interim CEO.

We believe value lies in the preferred shares as the companies look to sell assets and de-lever their balance sheet. Our thesis in preferred shares remains based on attractive valuations versus corporate bonds, the reduction in the size of the marketplace of approximately 20% as banks issue notes in lieu of preferred shares, and the upside benefit from the potential of rising rates. The majority of the market in preferred shares consists of rate resets which have their dividends increase alongside 5-year Government of Canada bonds yield increases.

The S&P/TSX was +1.7% while the Nicola Canadian Equity Income Fund was +1.4%. After very strong performance in November on the positive vaccine announcements, December was relatively calm. Investors seemed to weigh the long-term positives of the vaccine against the short-term prospects of more lockdowns. Financials and Materials were the strongest positive contributors to Index returns in December while Health Care (marijuana producers) was weak. Strong performance in Consumer Staples and our underweight in Health Care contributed positively for the month but this was offset by our underweight in Materials. The top positive individual contributors to the performance of the Nicola Canadian Equity Income Fund were Nuvei Corp, Norbord Inc, and Canwel Building Materials. The largest detractors were Kinaxis Inc, Air Canada, and Cargojet. There were no new additions in December. We sold Alimentation Couche-Tard.

The S&P/TSX was up +1.7% while the Nicola Canadian Tactical High Income Fund was +1.3% for December. The Nicola Canadian Tactical High Income Fund benefited from strong performance in Energy, but this was offset by relatively weak performance in Industrial and Materials.

In 2020, the North American oil and gas group had its worst performance in more than 30 years! However, crude oil prices, as well as the equities, have responded favourably in the last month to the early rollout of the COVID-19 vaccine as the market looks forward to ‘normalcy’. The Nicola Canadian Tactical High Income Fund has a Delta-adjusted equity exposure of 93% and the projected cash flow yield on the portfolio is 7.5%. In the month, there were no new additions or subtractions to the portfolio.

The Nicola U.S. Equity Income Fund returned +3.6% vs +3.8 for S&P 500. There has been a rotation into value names starting in early November after vaccine announcements and post-presidential election and momentum carried through to December. The Nicola U.S. Equity Income Fund’s performance during the month was driven by its exposure to Financial, Info Tech and Healthcare; the Financial exposure alone (banks, insurance companies and asset manager) contributed over 1/3 of the Nicola U.S. Equity Income Fund’s return. The difference in relative performance was mainly due to the Nicola U.S. Equity Income Fund’s overweight to Consumer Staples and underweight in Information Technology.

The Nicola U.S. Equity Income Fund ended the month with a delta-adjusted equity exposure of 97% (t had less than 5% in covered calls). The Nicola U.S. Equity Income Fund consists of high-quality names with relatively low leverage and attractive ROIC (14% normalized).

The Nicola U.S. Tactical High Income Fund returned +2.4% vs +3.8 for S&P 500. There has been a rotation into value names which started in early November post the vaccine announcements and the presidential election and has carried on last month. The Nicola U.S. Tactical High Income Fund’s performance during the month was driven by its exposure to Financial, Info Tech and Healthcare. The difference in relative performance was mainly due to the Nicola U.S. Tactical High Income Fund’s underweight Information Technology and less equity exposure in general (51% delta-adjusted equity exposure). Option writing was attractive with the Nicola U.S. Tactical High Income Fund earning double-digit premiums with double-digit break-evens for Puts options. We sold the remaining stake in Franklin Resources at month-end.

The Nicola Global Equity Fund returned +2.9% vs +3% for the MSCI ACWI Index (all in CDN$). The Nicola Global Equity Fund slightly underperformed the benchmark due to our relative underweight in Information Technology, one of the best performing sectors during the month, and our overweight to Consumer Staples which lagged other areas of the market in December. Performance was marginally offset by country/region mix with our underweight to the US which underperformed other International markets, and overweight allocations to Asia Developed and Emerging markets which performed well in December.

During the month we exited our remaining position in BMO Asian Growth & Income, consolidating the proceeds among our existing managers. Performance of our managers for the month: JP Morgan Global Emerging Markets +6.0%, Lazard +4.5%, BMO Asian Growth & Income +4.3%, Nicola Wealth EAFE +3.1%, C Worldwide +2.5%, EdgePoint +2.0%, and ValueInvest +1.1%.

The Nicola Global Real Estate Fund return was –0.6% in December vs. the iShares S&P/TSX Capped REIT Index (XRE) -2.8%. In 2020, the iShares S&P/TSX Capped REIT Index was -13.7% on a total return basis (-17.6% price return, ~+5% yield), while the Nicola Global Real Estate Fund was -2.5%.

This total return was well-below the TSX Composite and was also the weakest year of REIT underperformance relative to the TSX Composite in the past 23 years. No doubt the weak economic environment caused by the global pandemic has weighed on REIT sentiment as generally speaking, REIT performance improves when the economy is strong. The vaccine cannot be distributed fast enough for many REIT operators. The announcement of positive results from COVID-19 vaccine trials has increased our confidence in a recovery in fundamentals in 2H 2021.

Long-term, we are bullish on the real estate complex and we view the distributions paid by REITs as safe and represent a large yield pick-up vs. government bonds. We also believe that the sector trades cheaply compared to what the underlying property portfolios are worth. There were no new names added or subtracted in December.

The Nicola Sustainable Innovation Fund returned +11.5% (USD)/ +9.3% (CAD) in December and returned +65.7% (USD)/ +62.4% (CAD) for 2020. Beam Global, Xebec Adsorption, and EDP Renewables were the top contributors to performance while Array Technologies was the lone negative position during the month. No new names were added in December; however, we trimmed back our position in Plug Power on a series of positive news releases heading into year-end and topped up allocations to several existing names including Sunrun, Ormat, and TPI Composites.

We were defensively positioned with a higher cash balance heading into a pair of Georgia Senate runoff elections in early January which were viewed as toss-ups. If the Republicans managed to retain one of the two seats, it would mean an uphill battle for most of the highly ambitious clean infrastructure plans hoped for by the incoming Biden administration. The Democrats managed to flip both seats which now provides them the opportunity to enact more favorable policies for investments in renewables and clean technologies. Early reaction to these runoff election results has been positive for many of our portfolio holdings and we will use any pullbacks as opportunities to deploy our cash balance. While 2020 saw strong results, with the magnitude of the pending clean energy infrastructure plan in the US (guidance for $2T over 4 years) as well as broader mandates for decarbonization globally, we still believe there are significant future investment opportunities in these areas.

The Nicola Alternative Strategies Fund returned +1.6% in December. Currency was a large headwind detracting -1.0% for the month. In local currency terms since the Nicola Alternative Strategies Fund was last priced, Millennium returned +5.9%, Renaissance Institutional Diversified Global Equities Fund -1.3%, Bridgewater Pure Alpha Major Markets +1.7%, Verition International Multi-Strategy Fund Ltd +3.3%, RPIA Debt Opportunities +2.8%, and Polar Multi-Strategy Fund +2.5%.

We redeemed Winton during the month as we rebalanced the portfolio to focus more on our multi-strategy funds. Strong returns for Millennium were driven by exposure to arbitrage strategies. During the year, Millennium increased exposure to both fixed income and equity arbitrage while reducing their exposure in quantitative strategies and relative value long short equities. Trading in SPAC’s (special purpose acquisition company) and IPO’s (initial public offerings) helped drive returns higher.

An IPO is a stock market launch where a private company is listed on an exchange and the general public is then allowed to buy shares in the company. The IPO market was very strong in 2020 with names such as DoorDash and Airbnb posting very high returns the day they were listed. Millennium was able to gain access to these IPO’s that were well bid with the intention of capturing gains from the limited supply and outsized demand for the stock while selling down their position in the open market after the IPO.

The Nicola Precious Metals Fund returned +4.7% for the month while underlying gold stocks in the S&P/TSX Composite index returned +0.6% and gold bullion was up +4.5% in Canadian dollar terms. Despite large-cap gold stocks decoupling from gold bullion during the month, the Nicola Precious Metals Fund finished the year up 37%. The USD dollar fell during the month making gold cheaper for non-US holders while monetary and fiscal policies pushed inflation expectations higher, helping to move gold prices higher.

The Nicola Infrastructure and Renewable Resources Limited Partnership returned +0.6% for the fourth quarter of 2020 in USD terms. Currency contributed 0.9% to returns as the Canadian dollar strengthened during the quarter. Cash remains at elevated levels of around 44% as our investment to EagleCrest Infrastructure fund was pushed back to Q1 2021.

After being delayed due to COVID-19, our power generation facilities are starting to come online and thus Crown Capital returns have started to be marked above costs. Our power purchase agreements are in place where clients are purchasing electricity from our natural gas-powered cogeneration units. These units use natural gas to provide a more efficient source of both power and heat to clients at a lower cost than local utilities. Overall, for the Nicola Infrastructure and Renewable Resources Fund, returns in Macquarie and Brookfield were offset by Bonnefield as annual farmland valuations have come slightly below expectations.

In Q4 the Nicola Private Debt Fund returned +2.4% (or 3.4% before accounting for FX translation). USD investments account for approx. 30% of the Nicola Private Debt Fund, so the weakening USD negatively impacted returns by -1.0% during the quarter. The main driver of the strong quarterly performance was the Nicola Private Debt Fund’s co-investment in Project Jackson. A portion of the Project Jackson loan was converted to equity and sold during Q4 generating a $2.4MM (or ~1.0%) profit for the Nicola Private Debt Fund. Other top performance contributors included Project Steen, Project Karma and Project Access.

New capital deployment into direct loans and co-investments was also strong during the quarter totalling $33.2 million. Key new investments during the quarter included i) a $6.5 million senior secured asset-backed loan to a Canadian limestone quarry operator in partnership with Travelers Capital, ii) a US$7.5 million direct participation in a privately syndicated senior secured loan led by Antares Capital to finance a bolt-on acquisition for a Sponsor-backed insurance services business, and iii) a US$10.0 million co-investment in a Holdco Loan alongside Northleaf Capital.

The Nicola Private Equity Limited Partnership returned +7.4% in Q4. The largest contributor to performance was MDA, the Canadian space company which was a direct investment we made alongside Northern Private Capital in April of 2020. Other positive contributors included Micross (formerly called Corfin), a New Hampshire headquartered investment that we made with Behrman Capital Partners.

This was also one of the contributors to performance in our investment in their fund, Behrman Capital Fund VI. In terms of headwinds, a weaker USD was an approximately 280bps detractor to the quarter’s performance. New Investments included a company called More than Just Feed, one of the largest independent livestock feed producers in Western Canada, based in Strathmore, Alberta, where we invested alongside Highland West, a Vancouver-based Private Equity Manager. We also invested in a Secondaries Fund managed by Toronto-based Overbay Capital Partners.

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.