BY ROB EDEL, CFA
Highlights This Month
- THESE 6 U.S COMPANIES ARE DOMINATING THE STOCK MARKET
- WHY WE AREN’T WORRIED ABOUT FEDERAL RESERVE TIGHTENING
- THE STATE OF THE CHINESE ECONOMY AND WHY IT’S CONCERNING
- CONTINUING LOW OIL PRICES ARE TROUBLING NEWS FOR THE CANADIAN DOLLAR
- AN UPDATE ON THE U.S. ECONOMIC RECOVERY
- THE COST OF A MEN’S SUIT VS. DRY CLEANING IT: IS INFLATION ON THE RISE FOR SERVICES?
- GOOD HOUSING MARKET NEWS: STARTS AND PERMITS REMAIN STRONG
- WHY A CANADIAN RECESSION MAY BE INEVITABLE
- AUTO AND FUEL SALES LEAD RETAIL SPENDING THIS SUMMER.
- TORONTO AND VANCOUVER REMAIN HOUSING MARKET HOT SPOTS
THE NWM PORTFOLIO
Returns for NWM Core Portfolio increased 1.2% for the month of July. NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships. Actual client returns will vary depending on specific client situations and asset mixes.
Canadian equities were weaker in July, with the S&P/TSX down 0.3% (total return, including dividends). NWM Canadian Equity Income (formerly NWM Strategic Income Fund) lost 0.7% and NWM Canadian Tactical High Income gained 0.6%. Year-to-date, NWM Canadian Equity Income is up 0.7% while the NWM Canadian Tactical High Income has increased a stellar 4.2% versus a 0.6% increase in the S&P/TSX.
Much of the market’s return in 2015 has been driven by one stock, Valeant, which has doubled in value this year and overtaken the Royal Bank as the largest Canadian company by market capitalization. If Valeant were excluded from the index, instead of being up 0.6% year to date, the S&P/TSX would actually be down 2% so far this year.
Neither NWM Canadian Equity Income nor NWM Canadian Tactical High Income have a position in Valeant. The cash position in NWM Canadian Equity Income is currently 6.4% and approximately 3% of our positions are covered.
No new names were purchased during the month, though we added to our existing holdings in Linamar and Methanex. We were called away on Catamaran and did not re-purchase. As for NWM Canadian Tactical High Income, no new positions were added, but we continued to increase our existing positions in Ag Growth, Guardian Capital, KP Tissue, and Gluskin Sheff.
Foreign equities were stronger in July, with NWM Global Equity up 4.5% compared to a 6.4% increase in the MSCI All World Index and a 6.7% advance in the S&P 500 (in Canadian dollar terms). Of our external managers, Pier 21 Carnegie led the way with a 7.4% gain followed by Lazard Global Small Cap +4.1%, BMO Asia Growth & Income +3.6%, Edgepoint +2.2%, and Mackenzie Cundill +1.1%.
NWM U.S. Equity Income was up 1.4% in U.S. dollar terms and NWM U.S. Tactical High Income +0.7% versus a 2.1% increase in the S&P 500 all in U.S. dollar terms). There were no new purchases in NWM U.S. Equity Income. The fund has a cash position of 3.4% and 9% of the fund is covered. As for NWM U.S. Tactical High Income, no new long only positions were added.
The Canadian yield curve reversed course last month and flattened, with 2-year Canada yields decreasing from 0.48% at the beginning of the month to 0.41% at the end of the month, while 10-year Canada’s decreased from 1.68% all the way down to 1.44%.
The U.S. yield curve also flattened, but only because long rates moved lower. Short-term rates actually increased, likely in anticipation of an increase in Fed funds rates. 2-year treasuries in the U.S. started the month at 0.65% and ended the month at 0.67%, while 10-year treasury yields ended the month at 2.18%, down 17 basis points.
NWM Bond was up 0.3% with the PH&N short-term bond fund, which benefited from the decrease in short-term rates, up 0.5%. Our alternative managers provided mixed returns.
High yield bonds were also higher in July, with NWM High Yield up 1.6%. Some of this gain can be attributable to the weaker Canadian dollar, which declined nearly 5% in July.
Global bonds also benefited from the decline in the Canadian dollar, with NWM Global Bond up 2.7%.
The mortgage pools continued to deliver consistent returns, with NWM Primary Mortgageand NWM Balanced Mortgage both returning 0.5% in July. NWM Primary Mortgage had 8.6% in cash at month end, but could move closer to 3% given current projections over the next 90 days. The Balanced Mortgage had 11.1% in cash, but could move down to 5.4% if all mortgages pending and in negotiation close and mortgages schedule to be re-paid over the next 90 days are not extended.
The preferred share market slid lower for July with the S&P/TSX Laddered Preferred Share Index ETF down 4.6%. NWM Preferred Share was down 4.9%. The difference in performance was due to the ETF trading above the value of its underlying assets (which accounted for 0.77% of performance).
The volatility of ETF pricing around the value of its assets is indicative of the lack of liquidity in the marketplace. Larger market dislocations can exist because the market is retail dominated and currently investor sentiment is so poor many preferred shares trade with little support on the bid side. Fundamentally there is value in the market, but investors will need to be patient to ride out the volatility.
Real estate had a strong month in July, with NWM Real Estate up 2.1%, while the iShares REIT ETF increased 0.6%.
NWM Alternative Strategies was up 3.4% in July (these are estimates and can’t be confirmed until later in the month). Of the Altegris feeder funds, Winton, Millenium and Brevan Howard were up 8.9%, 6.8%, and 4.6% respectively. Hayman was down 3.0%. MAM Global Absolute Return Private Pool and RP Debt Opportunities were up 1.2% and 0.3% respectively while the RBC Multi-Strategy Trust was flat. Polar North Pole Multi-Strategy was down 0.2%.
Precious metals continued their volatile trend in July. After getting off to a strong start in January, with NWM Precious Metals up 21.9%, commodities have come under pressure, culminating in a 13.2% for NWM Precious Metals in July. For the year, the fund is down 2.3%. While the fund does have a 25% exposure to gold and silver bullion, over 70% is invested in gold and silver resource companies, which have tended to be more volatile than the underlying commodity.
Gold was down only 2.1% in July and is actually up 4.2% year-to-date in Canadian dollars. In U.S. dollar terms, gold is down nearly 8%. Of course, this is why one owns gold — as a currency hedge. In this case, it has provided an excellent hedge against the weak Canadian dollar.
JULY IN REVIEW
Most markets were stronger in July with the exception of Canada and China, which were down 0.3% and 13.6% (in local currency terms) respectively.
In a world where growth is scarce, investors are willing to pay for any growth they can find. Currently they are finding it in the U.S., and potentially Europe. Canada and China, not so much.
While the S&P 500 was up 2.1% in July, just six companies, Amazon, Google, Facebook, Gilead, Netflix and Walt Disney, account for the indexes’ 3.3% gain year to date.
This group of six stocks accounts for over half of the gain in the Nasdaq Composite Index. CNBC’s Jim Crammer calls the situation “FANG” an acronym for Facebook, Amazon, Netflix, and Google, whereby a few highfliers mask general market weakness.
Ned Davis Research recently highlighted the weakness in the broader market by pointing out that nearly as many S&P 500 stocks are hitting one-year lows as one-year highs — and the percentage of stocks trading above their 200-day moving average is on a steady decline.
Some are drawing comparisons between the recent lack of market breadth with the late 1990’s tech bubble, or even the 2007 market peak preceding the financial crisis.
This doesn’t mean a crash is inevitable, however.
The U.S. economy continues to make slow but steady progress and should lend support to corporate earnings. The market leaders mentioned above have clearly demonstrated superior, if not spectacular, earnings growth – but there are others.
Health Care, Consumer Discretionary, and Information Technology are sectors that have exhibited superior earnings growth and, not surprisingly, are leading the market higher this year.
Within these sectors, companies that are more domestically-oriented have outperformed, given the strong U.S. dollar and recovering U.S. economic growth.
Of course, a stronger economy can cut both ways; it should translate into better earnings, but could also lead to higher interest rates.
Not only would higher interest rates be detrimental for valuations, but they could push the U.S. dollar even higher, which would be bad news for earnings. Of course, higher interest rates would also increase the cost of capital and funding costs for corporate America.
Eventually, higher interest rates would also slow the economy, but as we have argued in the past, short-term interest rates are presently set at such low levels, they would have to increase substantially before negatively impacting the economy.
The Federal Reserve is going to raise short-term interest rates, probably in September, and maybe again in December, and maybe one or two times in early 2016.
Then they will stop. Inflation is too low, and the global economy too weak for more.
Also, rising short-term rates doesn’t mean long-term interest rates have to rise. Because many investors feel the economy is still very weak, they have been buying longer term bonds, thus keeping long-term interest rates in check.
Despite its recent strength, in the past the U.S. greenback has weakened after the Fed has started to tighten — although the divergent path of the U.S. economy versus that of other developed world economies could test this historical relationship.
Not only are we not worried about Federal Reserve tightening, we are also not concerned about the strength of the market over the past five years — we don’t feel a correction is inevitable.
Savita Subramanian of Bank of America Merrill Lynch recently pointed to data suggesting there is no relationship between historical five-year returns and the subsequent twelve months. Bull markets typically last anywhere from two to nine years, and the dispersion of the duration of past bull markets is high.
Volatility is another matter. Once rates start moving up, the threat — as unfounded as we think it is — that rates will move meaningfully higher will cause the market volatility. Short-term corrections can be expected.
As Ms. Subramanian points out, the market typically suffers three corrections of 5% or more every year, but quickly recovers the losses over the following 30 days.
Fears around a Fed hike in short-term interest rates could lead to increased market volatility in the near term, but when the market realizes the increases will be slow and measured, investors will gravitate back to equities.
What would make us less confident about the market?
Well, slower consumer spending would present serious problems for the U.S. economy and could signal a coming recession.
We don’t see this in the short term, but the risk of another downturn is one of the reasons the Federal Reserve desperately wants to increase short-term rates.
If the U.S. economy does weaken, other than another quantitative easing program, there is nothing the Fed can do to help the economy given short-term rates are already zero. They are effectively out of bullets and they want to reload.
Longer term, we worry about debt levels. Debt created the great recession and the delevering process has been disappointing — just ask Greece. The U.S. has made better progress than most, but demographics are working against them.
While the U.S deficit recently hit seven-year lows, Medicare and Medicaid spending are forecast to start taking an ever-increasing portion of U.S. government outlays with total spending on health care projected to represent 19.6% of U.S. GDP by 2024.
This is unsustainable and if U.S. politicians can’t agree on a solution, the markets will force them to find one.
Not the correction in Chinese stocks, which were lower again in July with the Shanghai composite down 13.6% in local currency terms, but what’s happening in the real economy.
Yes, GDP growth did hit the government’s 7% target in Q2, but as Bloomberg’s Tom Orlik points out, 0.5% of the increase came from the financial sector. A growing financial sector is good from a job growth perspective, but not if it’s reliant on a stock market bubble that is in the process of popping.
They are notoriously stable, released literally days after the end of the quarter, and never revised. It’s like they are making them up.
The U.S. by comparison takes a month to release preliminary numbers, follows up with two revisions over the following three months, and sometimes even makes additional revisions years later.
Looking at some of the underlying indicators that are harder to “smooth,” the Chinese economy appears to be slowing a lot more than official GDP growth would indicate.
Power consumption in June was up only 1.8%, auto sales turned negative, and railway freight and excavator demand remain solidly in negative territory. China’s National Bureau of Statistics called China’s 7% GDP growth in Q2 “hard won,” but who’s kidding who? The battle was likely lost a long time ago.
Citigroup estimates Q1 GDP growth was only 4.6% while the Conference Board thinks 4% is probably closer to the truth, and Q2 is likely about the same, or worse.
It’s important to keep in mind, however, that a slowdown in China’s economic growth is all part of the plan to rebalance the economy, and there are signs that progress on this front is being made.
While the manufacturing sector might be stagnating, or even contracting, the services sector is booming and estimated to have contributed nearly half of economic growth in Q2, its largest share ever.
In fact, American companies catering to Chinese consumers are singing a different tune than those exposed to the industrial sector with Harley Davidson, United Continental, and Apple all experiencing increased sales.
And even if China’s economy runs into problems, what is the impact for the global economy?
It is true China is the second largest economy in the world, but as Goldman Sachs points out, U.S. exports to China represent only 1% of U.S. GDP. Commodity exporters and Asian economies are more vulnerable, however, and China still accounts for a sizable chunk of overall global GDP growth.
According to J.P. Morgan, nearly one third of global growth over the past 12 months has come from China and they estimate a 1% decline in China’s growth rate would result in a -0.5% in global growth.
So yes, China matters.
And because China is a large importer of oil and other commodities, China especially matters to Canada.
We will take a look at Canada’s economy in more detail below, but suffice to say, the sharp correction in crude oil and corresponding pull back in business investment has taken a big bite out of Canadian GDP growth and the Canadian dollar, which has fallen in line with the currencies of other oil producing countries.
The energy sector accounts for about 10% of Canada’s GDP and more than 25% of business investment. Among advanced economies, in fact, Canadian GDP is predicted to take the biggest haircut, with the IMF recently reducing their estimate for 2015 GDP growth from 2.2% down to 1.5%.
Demand is part of the reason, with the global economy and (especially China) showing signs of weakness, but supply is more of an immediate concern with oil inventories continuing to build.
OPEC producers Saudi Arabia and Iraq have increased production, and if Iranian sanctions are lifted, even more crude will hit the market. A decline in higher cost North American production was expected to balance the market, but falling prices have merely forced American drillers to become even more efficient.
Some production will be curtailed as drilling slows, but as soon as prices start to move higher, more production will hit the market.
In the near future, demand, not supply, will be needed to balance the market, and this will take longer to work through.
Bad news for Canada and Canadian stocks.
Overall, some worrying signs in the markets with fewer and fewer companies participating in the market rally.
China remains a risk, as do lower oil prices for commodity exporters.
THE U.S. ECONOMY
Second quarter GDP came in at 2.3% and first quarter GDP was revised higher such that the U.S. economy grew 1.5% in the first half of 2015. Last year, U.S. GDP expanded at a 1.9% clip in the first half of the year, which in itself was pretty mediocre at best.
In fact the economic recovery, which is now six years old, has been pretty disappointing compared to previous recoveries.
Still, progress is being made and the decline in oil is responsible for some of recent weakness as most of the decline in capital spending is attributable to the energy sector.
Manufacturing remains strong with most purchasing manager indices in expansion territory. Consumer spending also looks promising, with the improved labour market and lower gasoline prices helping put more money in workers’ pockets.
The labour market continued on its path to recovery in July with the U.S. adding 215,000 new jobs. Jobless claims, in fact, fell to their lowest level since 1973 in mid-July.
Unfortunately, wage growth, which showed some promise last month, disappointed in July. The lack of wage recovery has meant workers have gained little ground versus inflation over the past six years, with low-wage earners actually suffering a drop in real wages.
The market is tightening, however. Companies are finding it tough to hire qualified workers and cite this as an even bigger issue than poor sales.
Wage growth is the last remaining piece to the U.S. economic recovery puzzle and one of the reasons the Fed could be hesitant to raise short-term interest rates.
Inflation moved slightly higher in June, but remains below the Federal Reserve’s 2% target. If not for the costs of shelter, in fact, inflation would have been cut in half as rental vacancy rates are near 20-year lows. Also pushing prices higher are services.
A recent Wall Street Journal article highlighted the different direction the price of services is taking compared to the prices of goods by comparing the price of a men’s suit to the cost of dry cleaning it.
While the price of a new suit has gone down 3.7% over the past five years, the cost to dry clean it has gone up over 9%.
It’s the same for entertainment. The price of a T.V. has declined nearly 60% over the past five years, but cable has gone up nearly 14%.
Inflation is a tricky thing to measure. CPI tells us there is no inflation, but our wallets tell us otherwise.
Both consumer confidence indicators were lower in July, but coming off high levels.
Like wage growth, retail sales disappointed last month after finally showing some promise. Even worse, the decline was broad based.
Retail sales can be volatile so we won’t read too much into the decline in June, but it is concerning.
The housing recovery continues to make solid progress. Existing home sales remain positive and are probably being held back to some degree by a lack of available inventory. New home sales moved down, but housing starts and building permits remain strong.
With household formation continuing to move higher and the increasing cost of renting making home ownership more attractive, we would expect demand for housing, both new and existing, to continue moving higher.
We are keeping our eye on consumer spending, but overall the U.S. economy remains on track. Wage gains and housing market recovery need to make more progress to confirm our optimism.
THE CANADIAN ECONOMY
In fact, June would need to produce GDP growth of 1% to avoid negative growth in the second quarter, a relatively high hurdle given current trends. Certainly the energy sector continues to weigh on economic growth, but the services sector also contracted in May, and manufacturing delivered a notable 1.7% decline.
Given the weakness in the Canadian dollar, this was a big disappointment. Realistically, it could take years for the lower loonie to meaningfully increase in the manufacturing sector, especially given the damage a strong Canadian dollar has inflicted on the manufacturing sector over the past few years.
Economists at CIBC, in fact, estimate that until the selloff, the Canadian dollar had been overvalued by 10% since 2009.
Well if Canada is in recession, someone forgot to tell the job market as Canada added 6,600 workers in July.
Granted, the quality was questionable, with full-time employment falling 17,300 and the private sector shedding 28,100 positions, but the unemployment rate was unchanged at a respectable 6.8%.
Over the past six months, in fact, Canada has added a net 11,000 positions, despite a rapidly contracting energy sector. So if Canada is in recession, it’s been pretty tame from a jobs perspective.
Also, wage growth was a robust 3.4% — well in excess of inflation. Employment is a lagging indicator, but so far so good.
The decline in the Canadian dollar could pressure CPI in future months, but slow economic growth and commodity deflation should help moderate the impact. Inflation remains a non-issue.
Retail sales in May came in higher than expected, led by auto and gasoline sales. Given the decline in consumer confidence in July, we would expect consumer spending to moderate over the next few months.
While the contracting energy sector may be hurting economic growth, the housing market continues to be a pillar of strength. The pillars are a little uneven, however, as red hot Vancouver and Toronto are again providing most of the growth.
Nationally, average house prices are up 9.6% in June versus last year. Excluding Toronto and Vancouver, however, prices are up only 3.1%.
Even within the Toronto and Vancouver markets, not all homes are created equal. In July, condo prices were up 5.1% in Toronto and 4.7% in Vancouver, while detached homes in both cities were up more than 10%.
Housing starts did fall in July, but are still at levels appropriate for current demographic trends.
A huge increase in exports in May gives some hope that June’s GDP could come in higher than expected and second quarter economic growth might end up in the black.
It’s going to be a close call. If Q2 GDP is negative, that would make it two quarters in a row, the technical definition of a recession. But as Stephen Harper commented in the first leader’s debate, the weakness is only coming from the energy sector.
The Bank of Canada surprised markets in July with another cut in the Bank of Canada Rate and Bank of Canada Governor Stephen Poloz lowered his 2015 GDP growth forecast to just 1.1%, but also insisted the other 80% non-energy related part of the economy is doing fine.
What did you think of July’s economic activity? Let us know in the comments below!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. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.