Highlights This Month
- Interest rates will rise, but when? Federal Reserve predictions
- Is the Eurozone economy finally making positive gains?
- China’s weakened growth in the global market
- Why did markets go up in February?
- U.S. economic growth in 2015 – it’s not just about oil prices
- Impressive gains in the job market not seen since the 1990’s
- Why we’re keeping an eye on consumer saving versus spending
- A sustained U.S. economy depends on this…
- The loonie was stronger in February — will the trend continue?
- Our outlook for the Canadian economy in the coming months
THE NWM PORTFOLIO
Returns for the NWM Core Portfolio increased 1.5% for the month of February. The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.
Canadian equities were materially stronger in February with the S&P/TSX up 4.0% (total return, including dividends), while NWM Canadian Equity Income (the former Strategic Income Fund) was up 3.2%, and NWM Canadian Tactical High Income +3.4%.
The cash position in NWM Canadian Equity Income is currently about 3.6%, and approximately 7% of our Canadian positions are covered. We added new positions in Prairie Sky and sold Canexus, Agrium, and Thomson Reuters. As for NWM Canadian Tactical High Income, no new positions were added during the month but we were called away on Methanex and Intact.
Foreign equities were strong in February with NWM Global Equity up 4.1%, matching the MSCI All World Index, and slightly above the S&P 500 (in Canadian dollar terms) return of 4.0%. Of our external managers, all were in positive territory led by Edgepoint at +7.5%, Pier 21 Carnegie +5.4%, Templeton Global Smaller Companies +4.5%, Mackenzie Cundill +1.2%, and BMO Asia Growth and Income Fund +0.3%.
NWM U.S. Equity Income was up 6.2% in U.S. dollar terms, and NWM U.S. Tactical High Income was up 5.0% versus a 5.7% increase in S&P 500, both in U.S. dollar terms. For NWM U.S. Equity Income we added a new position in satellite communications provider, Dish Networks Corporation. The fund has a cash position of 4.2% and 8.2% of the fund is covered. As for NWM U.S. Tactical High Income, we established a new short put position in Oracle.
Despite interest rates moving higher, the REIT market was positive with NWM Real Estate increasing 0.4% in February.
The mortgage pools also delivered positive returns despite the move higher in interest rates, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.5% respectively in February. 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 in no way is a predictor of future performance, are 4.3% for the Primary Mortgage and 5.7% for the Balanced Mortgage, or 6.2% if fully invested. Primary Mortgage had 2.9% in cash at month end, while Balanced Mortgage had 15.4% in cash.
The preferred share market was a bit more stable in February after a rough start to the year. However, the BMO S&P/TSX Laddered Preferred Share Index ETF was still in negative territory down 0.5% while NWM Preferred Share was up 0.1%.
The 5-year Government of Canada bond moved up to end the month at 0.73% although concerns still remain on further rate cuts by the Bank of Canada. February also brought to us four new rate reset issues bringing new activity for the year up to $1.6 billion.
The new supply matches closely to the $1.8 billion in redemptions we have had YTD. The primary market has been a solid source of returns for the fund, but the compressed timing of the new issuance means the market may take time to digest the glut of new supply.
With interest rates moving higher, it was tough going for the NWM Bond in February. 2-year Canada yields increased from 0.39% at the beginning of the month to 0.47% at the end of the month, while 10-year Canada’s increased from 1.25% to 1.30%. NWM Bond managed to increase 0.4% because our alternative managers all managed to generate positive returns during the month. Marret Investment Grade Hedged Strategies led the way, up 2.2%, followed by Arrow East Coast +0.6%, and PR Fixed Income Plus +0.2%. PHN’s Short Term Bond fund was down 0.2%.
High yield bonds also managed to overcome the interest rate headwinds in February with NWM High Yield Bond up 1.0%.
Global Bonds were weaker last month, with NWM Global Bond down 0.7%. Currency likely played a role as the Canadian dollar appreciated 1.7% against the U.S. dollar in February. No fear, however; the loonie has given it all back and more in early March.
NWM Alternative Strategies was down approx. 0.8% in February (these are estimates and can’t be confirmed until later in the month). Altegris feeder funds Winton, Brevan Howard, and Millennium were all down 1.8%, 2.2%, and 1.3% respectively while Hayman posted a 1.6% increase. A stronger Canadian dollar worked against results for all these funds last month.
SW8 also gave back a little performance in February, decreasing 2.2% while RP Debt Opportunities and MAM Global Absolute Return Private Pool increased 1.1% and 1.7% respectively.
NWM Precious Metals was down 5.7% in February with gold bullion down 7.1%.
February In Review
Equity markets more than made up for a sluggish start to the year with the S&P/TSX gaining nearly 4% in February and the S&P500 +5.7% (in U.S. dollar terms).
The question is why?
The U.S. economy is at best stable, and probably more accurately described as going through a soft patch.
Corporate earnings estimates have been coming down due to a strong dollar, weak energy sector, and stagnant global economy. Analysts are forecasting profits will decline for the second consecutive quarter — the first time this has happened since the financial crisis.
Adding to the weak domestic macro picture has been a never ending stream of winter storms hitting eastern states (and provinces), and the ports strike on the west coast. In fact, the only thing looking strong is valuations, which have been moving steadily higher.
Perhaps the best thing that can be said about stock valuations is they are not as high as bonds, which continue to defy forecasters and logic.
Unless economic growth stumbles and deflation becomes a reality, interest rates have to move higher at some point. Some point was February, as yields reversed course and rose in most developed markets last month, including the U.S. and Canada.
Speculation over if, when, and by how much the Federal Reserve will raise short term interest rates (for the first time since 2006) is behind most of the increase in bond yields during the month.
Will the first raise happen in June, or will the Fed wait until September — or even 2016? When they do rise, will it be just 25 or 50 basis points, or will the Fed tighten more aggressively over a shorter period of time?
According to OSK-DMG chief economist Thomas Lam, Fed tightening cycles last about one and a half years and result in cumulative rate hikes of about 3.25%, which is in line with what the Fed officials are guiding to.
The capital markets, however, are not even close to pricing in interest rate increases of this duration or magnitude. While the median Central Bank official’s projection for short term interest rates at the end of the year is 1.13%, the market believes rates will only get to 0.5%.
Likewise, by the end of 2016, the Fed believes rates will hit 2.5% on their way to 3.63% by the end of 2017, while traders believe short rates will only reach 1.35% and 1.84% by the end of 2016 and 2017, respectively.
Certainly the recent strength in the job market makes a strong argument that interest rates should start to normalize — meaning interest rates should be closer to the Fed’s 3.63% than the market’s 1.84%.
But the absence of wage inflation, or inflation of any kind, anywhere, would suggest that the Fed might have to dial their expectations back a little.
On the other hand, while the current economic conditions in the U.S. would historically justify interest rates closer to the Fed’s forecast, the capital markets have become accustomed to the current zero interest rate environment.
Care must be given to slowly wean investors off the massive monetary stimulus being applied by the Fed in moving towards a more normalized interest rate environment.
This is particularly true given bond yields are even lower in other developed economies, and even negative in some northern European countries.
Why invest in European bonds with skinnier yields when the U.S. economy is performing better?
The Fed increasing interest rates will drive even more foreign capital to the U.S., pushing the dollar even higher.
Good for European exporters, not so much for American companies selling abroad. The Federal Reserve is in a tricky spot.
Helping matters last month — and explaining why the U.S. dollar was weaker and bond yields were higher — wasn’t U.S. economic strength (which, as we mentioned was actually weaker at the margin), but was the result of signs that the European economy might be turning the corner.
Purchasing manager indices remain well into expansion territory at 53.3 in February versus 52.6 in January (anything over 50 is indicative of an expanding manufacturing and services sector), and Q4 GDP grew an annualized 1.4%, led by Germany and Spain.
Optimistically, the European Commission is forecasting economic growth for the Eurozone will hit 1.3% this year and 1.9% in 2016 versus forecasts of 1.1% and 1.7% six months ago. Certainly not what one would typically consider robust, but moving in the right direction.
Perhaps even more significantly, the EC believes every country in the Eurozone will grow this year, which would be the first time this has happened since 2007.
Also gaining momentum was private sector lending, which declined in January but by only 0.1%. Consumer confidence, which generally strengthened throughout the Eurozone in February, hit an eight year high.
Layer on the ECB’s bond buying program, expected to start March 9th, lower oil prices, and a four month extension of Greece’s bailout, and it’s no wonder investors are starting to look at Europe in a different light.
It’s not cheap, and challenges remain (just ask France), but it is cheaper than the U.S. markets and may have started to rebound.
While economic growth in Europe may be lending a much welcome hand to global GDP growth, a weaker Chinese economy looks to be negating much of the benefit.
This is significant given it has historically been the view that China required economic growth of 7% to 8% in order to create enough jobs to keep the masses in order.
But despite GDP growth falling to 7.4% in 2014, the unemployment rate in China remained low and wage growth continues to move higher. A declining working age population and decelerating urban growth rate may mean China only requires GDP growth of 4.5% to 5%.
Of course who knows what the real growth in China is. Given the fact that China’s Central Bank cut interest rates in late February for the second time in less than four months, one can only assume there is some angst over the rapidly cooling real estate sector and bloated corporate debt levels.
No fear, however. India has taken up the slack with fourth quarter GDP growing 7.5% versus China’s fourth quarter GDP growth of only 7.3%.
Even better, India’s Finance Minister believes India could deliver growth this fiscal year of 8.1% to 8.5%.
If true, India’s annual growth rate could top China’s for the first time since the 1990’s.
Of particular appeal is India’s young and educated work force. Nearly half of India’s 1.25 billion population is under the age of 25.
Historically, India’s potential has been hampered by bureaucratic and regulatory roadblocks. The World Bank, in fact, recently ranked India as the 142nd hardest country to do business in (out of 189 countries).
Investors are hoping new Prime Minister Narendra Modi will be able to make good on his election promise to change India’s ways. After only eight months on the job, Modi has implemented a raft of business-friendly reforms, but deeper changes are needed if momentum is to be maintained.
As Chinese, Japanese and European leaders can attest, these can be politically challenging to implement in the longer term.
Capital is starting to flow to India, but caution is warranted.
Money shifting out of bonds and into stocks is likely the main reason. The prospect of a stronger European economy is also a factor.
We cannot, however, dismiss the fact that markets were merely bouncing back from a weak January, and market volatility is something we are going to have to get used to in 2015.
The U.S. Economy
For 2014 in total, GDP grew as inflation adjusted 2.4%, which is higher than the 2.2% average experienced over the previous four years — but well below the 3.4% average the economy grew during the 1990’s.
Importantly, however, consumer spending remained a strong 4.2% and business investment grew at a 4.8% pace.
Capital investment — a narrower subset of business investment that includes spending that improves or extends the life of existing physical assets — increased 15% to a five year high of $166 billion in Q4.
Retrenching energy companies will provide a headwind for business investment in 2015, though the sector only makes up about 7% of U.S. business investment and 1% of GDP.
A survey by the National Association of Manufacturers cited rising health care costs as the manufacturing sector’s top challenge this year. Other top concerns included the West Coast port strike, the strong U.S. dollar, and problems attracting qualified workers.
Despite this, the manufacturers still expect the economy to grow 3%.
We expect the resolution of the west coast port strike will calm some of these concerns, but it could take a couple of months before shipping logistics return to normal.
In addition, a series of severe winter storms on the East Coast will likely result in a sluggish first quarter — and likely explains the weakness seen in several regional purchasing manager indices.
All in all, a weak start to the year to go with a weak end to last year.
We expect the U.S. economy to gain strength in the second half of 2015 but concede America has hit a bit of a soft patch. Still, growth is better here than almost anywhere else.
For the twelfth straight month more than 200,000 jobs were created — a feat not matched since 1995.
The unemployment rate also moved down to 5.5%, the top end of the Federal Reserve’s long-run range of 5.2% to 5.5%.
What remains missing, however, is wage growth, which moved back down to a meager 2%.
The U.S. is doing great at creating jobs; it’s just that they are concentrated in low paying industries, like retail and food service. Wages in these sectors are in fact increasing, however, as evidenced by Walmart and TJX’s recent announcement of their intentions to raise pay well above minimum wage levels.
Surely increased salaries in the rest economy are just around the corner?
Headline inflation continues to move lower, but is mainly due to falling energy prices, which decreased 9.7% in January and nearly 20% compared to year ago levels.
Gasoline itself was down 18.7% for the month and 35.4% over the past year. Also impacting prices is the strong U.S. dollar, which on a trade weighted basis is up 10% year over year.
With the combined value of U.S. imports and exports comprising nearly a third of the U.S. economy, the direction of prices outside of the U.S. is having a bigger and bigger impact on domestic inflation levels.
The question is whether it is enough to prevent the Federal Reserve from increasing interest rates, or will the moderating price levels be seen as temporary.
Consumer confidence fell in February, but it was coming off very strong levels last month. We wouldn’t read too much into this.
Retail sales and consumer spending fell for the second month in a row in January.
However, adjusted for inflation and falling gasoline prices, spending managed to move into positive territory.
Consumers appear to be hanging on to at least part of the windfall they are getting at the pumps as the personal saving rate moved higher in January.
We don’t think this is a trend, but because the impact on economic growth would be so severe if it did become a trend, we plan to keep a close eye on it in the coming months.
Not much new to report in the housing market. Momentum picked up in the second half of 2014, but activity in January was uninspiring.
Like wage growth, we continue to believe an improving job market will result in a continued recovery in the housing market. Stay tuned!
The trade deficit narrowed slightly as both exports and imports declined.
Lower crude oil prices were a major driver in the drop in imports, as the petroleum trade deficit hit its lowest level since November 2003.
Lower energy prices also impacted exports, as the U.S. is a major seller of refined petroleum products. The stronger dollar and west coast port strike also helped reduce both imports and exports.
It’s the one piece of the puzzle needed to confirm a sustained economic recovery in the U.S. To be continued…
The Canadian Economy
Canadian fourth quarter GDP came in at a better than expected 2.4% as the year ended on a high note with December GDP increasing 0.3%. For the year, Canada posted 2.5% growth — slightly higher than the 2.4% delivered by the U.S. economy.
Part of the stronger performance in Q4 came from higher inventories, however, and most forecasts have Canadian economic growth decelerating to 1.5% in the first half of 2015 before rebounding in the second half.
For the full year, GDP growth should come in around 2%, below that of the U.S., but higher than Europe or Japan. Weakness is already evident in the RBC Purchasing Manager’s Index which plummeted into contraction territory, hitting the lowest level in its five year history.
The value of the loonie has historically shown a strong correlation with the interest rate spread between Canadian and U.S. 2-year government bond yields. Even if the Bank of Canada doesn’t lower rates again in the future, the loonie could come under pressure if the 2-year spread widens due to higher U.S. interest rates.
Traders are generally positioned for a weaker Canadian dollar, and are net short the loonie, which is the case for most currencies against the U.S. dollar.
Canada lost a net 1,000 new jobs in February, with 34,000 new full-time positions being more than offset by the loss of 35,000 part-time jobs.
While a loss is never a good thing, many were expecting worse given the deterioration in the energy sector, and there were some underlying signs of weakness.
The private sector bled 24,000 jobs in February, while most of the gains came from the public sector, which added 24,000 workers. Predictably, the resources sector accounted for 17,000 of the lost private sector jobs with Alberta, Saskatchewan, and Newfoundland & Labrador home to 18,000 of the displaced workers.
The hope is much of the pain in the energy patch will be front end loaded, and should peak in the first half of the year — though the trickle down impact to other regions and industries could push that timeline out.
Also, the Target store closings have yet to show up in the numbers, which means upwards of 17,000 new layoffs could show up in future months, unless other retailers pick up the slack and hire some of these displaced workers.
Headline inflation was negative in January, but this was mainly due to lower oil prices. Core inflation was unchanged and above the Bank of Canada’s 2% target.
The fall in the Canadian dollar is likely behind much of the increase, as all categories were up, with the exception of transportation. Food prices remain elevated, increasing 4.6% year over year with fruit up 8.9% and vegetables +10.9%.
Consumer confidence tumbled in February, with only Quebec immune from a decline.
Retail sales in December also took their biggest monthly hit in more than four years, falling 2%, though lower gasoline prices accounted for much of the decline as gas station sales were down 7.4%. Excluding gas station sales, retail sales were still down 1.2%.
There is some speculation that December’s poor showing could be the result of Canadian shoppers shifting more holiday shopping to November in order to take advantage of U.S. style black Friday sales. Also, the increased use of gift cards could shift spending into January as purchases are not recorded until the gift cards are used.
Regardless, the decline in oil prices and its impact on the job market is a concern for 2015 and is compounded by the heavy consumer debt loads Canadians presently bear.
According to the Bank of Canada, Canadians increased their debt by 4.6% in January, mostly due to a 5.4% increase in residential mortgages. Fortunately, mortgage rates fell to 10-year lows in the month as well.
The housing market has started the year on a weak note with existing home sales falling for the third consecutive month, and down 2% versus level a year ago.
Prices were down slightly from the previous month, and while prices are still up over 3% compared to last year, this is the smallest year over year increase since May 2013.
Vancouver and Toronto remain firm markets with sales flat in Toronto and up 5.3% in Vancouver. Predictably, sales were down nearly 24% in Calgary and nearly 10% in Edmonton.
Housing starts were even more concerning, dropping nearly 19% year over year in February with permits in January falling nearly 14%.
Most of the weakness was due to a 25% drop in multi-family units, as concerns of unsold condos have developers scaling back plans. Weather likely also played a role.
Canada’s trade deficit widened in January to its highest level in two and a half years, as oil exports were down nearly 15% from December, falling for the eighth consecutive month. Net exports were a big contributor to GDP growth in 2014, but it’s not looking so good for 2015.
It’s not showing up in the numbers yet, but the abrupt change of fortunes in the energy sector will mean continued job losses. A correction in the housing market in the commodity-oriented provinces of Alberta, Saskatchewan, and Newfoundland & Labrador will also have an impact.
The severity of the overall Canadian economy will largely be determined by how long oil prices stay low, but more importantly, how much the weak Canadian dollar and stronger U.S. economy helps growth in the rest of the country.
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.