Market Commentary: A He Said Xi Said Situation.


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Portfolio

Returns for the Nicola Core Portfolio Fund were down 1.0% in the month of May. 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 +0.5% in May, and is +3.4% year-to-date. The Nicola Bond Fund’s component returns benefited from declining interest rates over the month as the Canada government 10-year yield fell from 1.72% to 1.48% and the Canada government two-year yield dropped from 2.27% to 1.92%. Arrow East Coast Investment Grade Fund II contributed another positive month at +0.7% and has returned +6.7% year to date. With lower interest rates, the Nicola Bond Fund net current yield has declined to 2.4%.

The Nicola High Yield Bond Fund returned +0.2% in May, and is +3.8% year-to-date. The high yield bond market had its first negative month of the year as credit spreads widened substantially due to international trade tensions. But while the BoAML US High Yield Index was selling off   -1.3% in the month, the Nicola High Yield Bond Fund’s long/short high yield managers showed their uncorrelated abilities, with the Picton Mahoney Income Opportunities Fund returning +1.6% in May, and the Apollo Credit Strategies +2.1%. At the end of May, the Nicola High Yield Bond Fund increased allocation to PH&N High Yield Bond Fund, Oaktree Global High Yield and Apollo Credit Strategies, notably increasing its U.S. Dollar exposure from 40% to 50%. The Nicola High Yield Bond Fund’s net yield remains around 4%, with low duration of 2.3 years.

The Nicola Global Bond Fund was -0.2% for the month.  The Nicola Global Bond Fund’s exposure to emerging market currencies (Latin America) and U.S. high yield bonds (credit spreads widened) detracted from performance.  The underlying managers’ duration exposure was mixed with PIMCO long U.S. & Australia’s duration adding to performance while Templeton’s short U.S. duration detracted from performance as U.S. 10 year interest rates decreased 37bps to 2.13% (lowest level since September 2017). Performance of our managers in descending order: Manulife Strategic Income Fund +0.7%, PIMCO Monthly Income +0.3%, and Templeton Global Bond -0.7%.

The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.3% and +0.5% respectively last month. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 3.9% for the Nicola Primary Mortgage Fund and 5.6% for the Nicola Balanced Mortgage Fund. The Nicola Primary Mortgage Fund had 25.4% cash at month end, while the Nicola Balanced Mortgage Fund had 9.2%. Given the current high cash level in the Nicola Primary Mortgage Fund and the current lack of product available in the market, we are actively discussing strategic alternatives for this fund.

The Nicola Preferred Share Fund returned -2.9% for the month while the BMO Laddered Preferred Share Index ETF returned -3.5%.  The preferred share market held relatively stable for the better part of the month before falling in sympathy with the equity markets during the last week. Overall the preferred share market experienced the worst month this year as the five year Government of Canada bond yields fell 17 basis points to 1.37%. During the month we deployed cash within the portfolio, increased our weight in Element Fleet Management, and participated in the new CIBC issue. During May, CIBC came to market for $300 million with a 5.15% coupon preferred share rate reset with a 362 basis points reset.

After a period of relative calm for the first four months of the year, volatility spiked in May as a result of numerous negative headlines, tweets and announcements regarding trade negotiations between China and the US. The S&P/TSX was down 3.1% while the Nicola Canadian Equity Income Fund was -4.2%. Energy, Health Care and Financials were the top three contributing sectors. The top detracting sectors were Materials, Consumer Discretionary, and Info Tech. We added Dream Industrial REIT and Ag Growth International. Top contributors to performance were Air Canada, Park Lawn, and Heroux-Devtek. Largest detractors to performance were Interfor, Methanex, and Great Canadian Gaming.

The Nicola Canadian Tactical High Income Fund returned -4.3% vs the S&P/TSX’s -3.1% return. The Nicola Canadian Tactical High Income Fund’s relative underperformance was due to being underweight rate sensitive sectors (REITs & Utilities) and defensive sector (Consumer Staples).   A few names within our consumer discretionary & materials sectors also dragged down performance in the month. The U.S./China breakdown in trade-talks was felt by global markets and Canada was no exception.   The Canadian stock market sold off as risk aversion took hold and the Canadian option volatility index spiked +32.6% by month-end. The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 64.6% (63.6% prior) and remains defensively positioned with companies that generate higher free-cash-flow and have lower leverage relative to the market. No new names were added to the Nicola Canadian Tactical High Income Fund this month.

The Nicola U.S. Equity Income Fund returned -5.7% while the S&P500 returned -6.3%. Defensive sectors Utilities and Consumer Staples, as well as stock selection such as Medtronic, Nextera Energy, and AIG more than offset declines in NVidia, Valero, and Bank of America. We exited Union Pacific and HP and no new names were bought.

The Nicola U.S. Tactical High Income Fund matched the S&P 500’s -6.4% last month. The Nicola U.S. Tactical High Income Fund was underweight in rate sensitive sectors (REITs & Utilities) and defensive sectors (Healthcare & Staples, which hurt relative performance in May).   A few names within our Consumer discretionary & Industrial sector (Delphi & FedEx) also dragged down performance in the month. The breakdown in trade talks between the U.S. and China and the May 5th Trump tweets caused global markets to sell off in early May and continued throughout the month as Trump later threatened tariffs on Mexico in regards to border security.

The geopolitical uncertainty was reflected in the options market where the CBOE volatility Index increased 41% by month-end. The Nicola U.S. Tactical High Income Fund was very patient in deploying capital to take advantage of the increased volatility and reduced equity valuations.   The Nicola U.S. Tactical High Income Fund’s delta-adjusted equity increased from 56.1% from 35.6%. One new name was added to the portfolio, Lowe’s.   Lower valuation and higher implied volatility relative to Home Depot gave us the opportunity to get back into this name. The portfolio remains defensively positioned with a lower valuation multiple, and higher free-cash-flow and lower leverage relatively to the S&P 500.

The Nicola Global Equity Fund returned -3.5% vs -5.1% for the MSCI ACWI (all in CDN$).

Our overweight in the defensive Consumer Staples sector and underweight in Information Technology were positive drivers of relative performance, as was being overweight International Equities (non-North American). Performance of our managers in descending order was: ValueInvest: -1.4%, CWorldwide: -3.2%, BMO Asian Growth and Income: -3.6%, Lazard Global Small Cap: -4.2%, NWM EAFE Quant: -4.3%, Edgepoint Global: -4.8%.

The Nicola Global Real Estate Fund was +1% vs. the iShares (XRE) +1.6%. Publicly traded securities make up 30% of the fund. The Canadian 10 year bond yields moved down in the month of May from 1.71% to 1.49% as REITs outperformed the broader TSX Index. Overall we think that conditions are good. We are focused on reasonably valued REITs with superior per-unit growth profiles.  We added Minto Apartment REIT to our portfolio in May as we think that the three year outlook for Apartments are very strong and that this area should see strong NAV growth.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag. As of May 31st, April 30th performance for the Nicola Canadian Real Estate LP was +0.2%, Nicola U.S. Real Estate LP +1.5%, and Nicola Value Add LP 1.6%.

The Nicola Alternative Strategies Fund returned 0.7% in May (these are estimates and can’t be confirmed until later in the month).  Currency contributed 0.6% to returns as the Canadian dollar weakened through the month. In local currency terms, Winton returned -2.5%, Millennium +1.1%, Verition International Multi-Strategy Fund Ltd 0.0%, Renaissance Institutional Diversified Global Equities Fund +2.8%, RPIA Debt Opportunities -0.5%, and Polar Multi-Strategies Fund +0.3% for the month. Despite weak returns in risk markets, the Nicola Alternative Strategies Fund was able to maintain positive performance in a difficult environment. Renaissance achieved strong returns through the month as quality companies (less debt, less volatile earnings) outperformed their counterparts. Winton was weaker through the month as commodities detracted from returns. Long positions in energy coupled with short positions in grains both hurt the fund as WTI crude had a sharp decline in May falling more than 16%, reversing the trend upwards that started at the beginning of the year.

The Nicola Precious Metals Fund returned +4.8% for the month while underlying gold stocks in the S&P/TSX Composite index returned +3.2% and gold bullion was 2.7% higher in Canadian dollar terms. Strong returns in the precious metals fund were driven by Atlantic Gold and TMAC Resources.

 

May in Review

Equity returns and yields came under pressure in May as the trade war between the U.S. and China gained strength and swept across global capital markets, leaving a path of destruction in its wake. In the U.S., the S&P 500 fell 6.4% while China’s Shanghai Composite declined -6.1%, Europe’s STOXX 600 -1.7%, and Japan’s Nikkei 225 -7.4% (all in local currency terms).

Our S&P/TSX faired relatively well, down only 3.1%. The decline in bond yields was even more dramatic, with 10 year U.S. Treasury’s ending the month at 2.13%, down 38 basis points to its lowest level since September 2017. Canadian 10 year Government yields declined to June 2017 levels, down 22 basis points to 1.49%. German 10 year Bunds declined to a record -0.20% (not a typo) while Japanese 10 year Government Bonds traded down to -0.09%. A negative harbinger for the rest of the year, or a buying opportunity for investors willing to bet a recession is not on its way? In order to answer this question (or at least add some context around it), let’s look at last month’s market action and what drove it in a little more detail.

 

Decline in bond yields concerning for investors

The decline in equity prices was painful for investors, but it was the decline in bond yields that was perhaps more concerning last month. Lower yields are good for bond returns and helped offset some of the losses in global equity portfolios (that’s diversification 101 at work), but the speed and veracity of the decline was concerning. And not just in the U.S., but globally. 10 year government bond yields in both Canada and the U.S. plummeted to their lowest levels in nearly two years, while German 10 year Bunds declined to their lowest level on record with a negative yield of nearly a quarter of one percent. In Britain, 10 year Gilts fell almost as sharply as after the Brexit vote in 2016. During last December’s correction, yields declined, but it was falling stock prices that garnered most of the headlines and concerned investors. Last month, bond yields took center stage.

On November 8, 2016, the day President Trump was elected, the 30 year U.S. Treasury was yielding 2.62%. Post the election, yields moved higher, as Trump cut taxes and economic growth firmed. By November 2th, 2018, nearly two years after the election, yields topped 3.45% and have been falling ever since. As of the end of May, 30 year Treasury yields had fallen to just less than 2.57%, thus wiping out the entire post-election rise in long term rates. Stocks on the other hand are still well above their November 8, 2016 levels with the S&P 500 gaining over 35% (or 12.5% annualized). Bond investors are clearly seeing a much gloomier world than stock investors.

That’s not to say equity investors are giving the economy the “all clear” signal. The U.S. technology sector has been selling off since late April, particularly the semiconductor index. U.S. small cap stocks have also underperformed large cap stock, and on international markets, Korean equities have been sold off over 9% since the middle of April. All four of these markets are commonly used by strategists as a barometer for the global economic growth.

The indicator most investors have their eye on, however, is the shape of the U.S. yield curve, namely the three month versus 10 year Treasury’s. A near perfect recession predictor, the yield curve inverted in late March for the first time since before the financial crisis, but only briefly and not by a large margin. Last month, the yield curve inverted again, but this time the inversion looks to have legs. It’s more inverted, and staying that way. Credit Spreads and stock prices, however, are still not pointing towards a recession, and perhaps more importantly, neither is the real economy. Consumer sentiment is still very strong and manufacturing and non-manufacturing indices (service) remain at levels associated with an expanding economy.

What’s spooked the Bond market, and to a lesser degree, the stock market, is the trade war between the U.S. and China and the potential for it to expand and derail global growth. Talks broke down in early May and little forward progress has been made since. On the contrary, after increasing tariffs to 25% on $200 billion of Chinese imports on May 10th, the U.S. is eying 25% tariffs on an additional $325 billion in Chinese goods. China retaliated on May 13th with higher tariffs of their own, but they are limited in their response given U.S. exports to China total only about $150 billion. Chinese leaders don’t appear likely to bow to the pressure being applied by Trump and his American negotiators, however, and are especially cognizant of appearing weak to the Chinese people. Chinese media has been quick to highlight the resiliency of the country’s economy and are appealing to their citizen’s patriotism by showing old Korean War movies on TV which highlight China’s role in the conflict. President Xi also used the term “the new Long March” in recent speeches as he prepares the Chinese people for a drawn out battle.

Markets are focused on the results of the trade war.

Why did the trade deal fall apart, and even more importantly, can it get back on track? It’s a bit of a He said Xi (pronounced “she”) said situation, but here is what we know, or think we know. The U.S. thought they had the framework of a deal worked out in a 150 page draft deal until China sent a draft back riddled with edits and changes, prompting Trump to balk, or in his case, tweet, and threaten more tariffs.

Exactly why China appeared to back away from what U.S. negotiators thought had been agreed to is unknown. Some believe China saw Trump’s criticism of the Federal Reserve’s interest policy as a sign the U.S. economy was weaker than many thought and concluded Trump needed to make a deal. Others speculate there was some confusion on the Chinese side as to the terms, which was only evident when it was translated into Chinese, or that China’s chief negotiator overestimated what he could sell to Chinese leadership.

China is especially reluctant to change domestic laws in order to resolve some of America’s core complaints. For their part, China has actually issued a white paper on the trade talks, laying the blame squarely on the U.S., of course. Where we go from here is what the market is focused on. President Trump and President Xi are expected to meet at the upcoming G20 meetings at the end of June and many feel a deal can still be made, especially since it appeared we got so close. If there is no progress and tariffs become a long term reality, global trade, which has already been declining since 2011, could come under more pressure. But it’s not just tariffs the market is worried about.

In May, the U.S. put Chinese telecom conglomerate Huawei on an entity list, requiring U.S. companies to obtain a government license in order to sell products to the Chinese telecom flagship. The move could potentially cripple the firm if it prevents them from obtaining crucial components from U.S. suppliers.

The Trump administration is also said to be considering adding Chinese video surveillance giant, Hikvision, to the list. China has countered by threatening to create an “unreliable entity list” of their own, targeting foreign companies, organizations and individuals they feel disrupt supplies to Chinese companies for “non-commercial purposes”. Other levers China could pull include dumping their vast horde of U.S. Treasury’s, which would push U.S. interest rates up and the U.S. dollar down, or limit the sale of rare earth minerals to U.S. companies. It’s unlikely they will do either. Dumping U.S. Treasury’s would be counterproductive to Chinese interests given a weak dollar and strong Chinese Yuan would hurt Chinese exporters. The value of their holding would also take a hit.

Restricting the sale of rare earth minerals is a more likely target and could cause real problems for U.S. companies, especially in the short term. Rare earth minerals refer to 17 chemically related elements found in mineral form with properties useful for making electronics more efficient. They are used in a number of technology products, from smart phones and electric vehicles, to strategically important military applications and products like the F-35 fighter jet. According to a 2103 Congressional Research Service report, a single F-35 requires approximately 920 pounds of the minerals. The U.S. Geological Survey estimates China supplied 71% of the World’s supply last year of rare earth mineral and it is believed the U.S. relies on China for 80% of its requirements.

It’s a double edged sword for China, however. Despite what the name implies, rare earth minerals aren’t actually that rare. Cerium, for example, is more common in the Earth’s crust than copper. Mining and processing the mineral is capital intensive and heavily polluting, however, one of the reasons production has gravitated to China. China might be able to block access for a while, but alternate supplies will be developed in a free market structure and result in market share losses for China in the future.

Also, global supply chains are complicated. Cutting the U.S. customers out would likely require limits to all foreign buyers, and maybe even Chinese firms exporting product to global customers. Other levers China could pull include advising the more than 350,000 Chinese students paying top dollar to study in U.S. University’s to choose a different destination, or warn the 162 million Chinese tourists spending $30 billion in the U.S. (according to China’s National Bureau of Statistics) that the U.S. is a risky place to visit and they should also consider a different destination. These moves would hurt American businesses, but it’s questionable whether the impact would be that great.

Perhaps China’s biggest stick lies in convincing American voters the trade war and resulting tariffs are hurting them more than China. President Trump likes to claim the U.S. is collecting billions in tariffs from Chinese exporters, and is happy to continue to do so for as long as it takes.

In reality, however, this is only the case if Chinese exporters aren’t able to pass through the cost of tariffs to American importers. Unfortunately for Trump, prices for Chinese imports affected by the tariffs have been moving higher, indicating American businesses are actually bearing at least some of the cost. The fact CPI for nine of the tariff impacted categories has also been moving higher means some of this cost has also flowed through to the U.S. consumer. According to the New York Federal Reserve, tariffs have cost the average U.S. household an average of about $831, almost as much as the $930 the Urban-Brookings Tax Policy Center estimates the average middle earner saved from the 2017 tax cuts.

 

Lower consumer disposable income looks to be adding pressure.

Lower consumer disposable income is bad for economic growth, which already looks to be under pressure. Of particular concern is business investment, which is considered essential if the current economic cycle is to be extended. There is a limit to how much the consumer can continue to spend, corporate America also needs to do their part and there are signs businesses are starting to pull back.

Global manufacturing indexes have also turned sharply lower, though they are still at levels associated with a growing manufacturing sector, in the U.S. anyways.   To be fair, however, most analysts were forecasting U.S. economic growth would slow in 2020 and 2021 even before trade negotiations between the U.S. and China broke down in early May.

In their June forecast, the World Bank lowered their forecast for 2019 global growth materially below their January forecast, though they believe growth will rebound next year. If the trade war gains strength and broadens, U.S. and global economic growth rates will likely need to be moved down even further.

While it’s true China might take an even bigger economic hit from the trade war, President Xi has an advantage much coveted by President Trump; the power to use fiscal and monetary policy to guide the economy through any rough patch created by the trade war. Trump needs either Congress to approve any increase in fiscal spending or the Federal Reserve to lower interest rates. President Xi merely needs to write a memo.

 

Fiscal policy relief before the 2020 election a pipe dream

Forget Congress. With the Democrats controlling the House, any fiscal policy relief before the 2020 election is a pipe dream. The question the market is grappling with is whether the Federal Reserve will play ball. Based on the belief economic growth is set to materially weaken, the market has started to discount a cut in overnight borrowing rates, believing the Federal Reserve will take a page out of its 1995 and 1998 playbook and implement an insurance rate cut by preemptively lowering overnight interest rates even though current economic data may not warrant such a move. Futures markets are presently signaling about a 20% change the Fed cuts rates in June (next Fed meeting is June 18-19) and an 83% chance of at least one cut at or before the July 30-31 meeting.

According to CME Group, futures markets have priced in a 98.5% chance of a cut by the end of the year and a 57% chance the Fed actually cuts three times (75 basis points) in 2019. On a three month rolling basis, one year forward rates have had their biggest move (downward in this case) since Refinitiv started collecting data in 2011. Speaking on behalf of the Fed, Chairman Powell has conceded a rate cut is in play, stating they (the Fed) are closely monitoring the recent escalation in trade tensions and could respond to any economic deterioration by cutting rates. He also said, however, “We do not know how long or when these issues will be resolved”. The Fed is in a tough spot. The market expects them to cut rates and will be disappointed if they don’t. But let’s face it, the deterioration in trade negotiations was unexpected and caught the market off guard. Who is to say a surprise deal could happen just as quickly.

 

The Federal Reserve needs to give the market what it wants, a rate cut.

The path of least resistance is for the Fed to give the market what it wants, a rate cut. Financial conditions have tightened, not as much as they did at the end of 2018, but as shown by the Bloomberg financial conditions index, financial conditions did spike higher in May. Morgan Stanley points out that when the impact of quantitative easing is considered, the Federal Reserve has actually tightened over 600 basis points since ending QE in 2014. Perhaps the Fed has done enough? In the eyes of the market, as a result of slower global economic growth and low inflation in the face of an escalating global trade, the Fed has done too much and needs to cut.

Without the U.S. economy showing material signs of deteriorating, however, the Fed is hesitant to act based on the trade war alone. No one really knows what’s going to happen, and to base monetary policy on tweets and threats from the President would appear to be poor policy. Case in point, Trump threatened new tariffs unless Mexico made moves to secure their southern border. In the end, a deal was reached and the tariffs were indefinitely suspended, but the market didn’t know it would turn out to be a non-issue.

There are too many unknowns in the market right now to have much conviction. Does the domestic U.S. economy have enough strength to compensate for a slowing global economy? What will be the impact of the trade war and how will the trade war be resolved? Will the Fed have the market’s back and cut rates, or will they wait too long and let the economy fall into recession?

The bond market says yes, the Fed has waited too long and a recession is coming. The stock market, well it’s not so sure. According to Leuthold chief investment strategist Jim Paulsen, in the past when the real economy has been signaling optimism while the bond market and yield curve is flashing red, stocks have gone on to outperform over the following six months. When bond traders are spooked but Main Street is confident, Paulsen recommends sticking with Main Street. For the time being, we’re sticking with Main Street, but we’re keeping a close eye on what the Bond Traders are saying.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Returns are quoted net of fund/LP expenses but before Nicola Wealth portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. For a complete listing of Nicola Wealth Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg. Effective January 1, 2019 all funds branded NWM were changed to the fund family name Nicola. Effective January 1, 2019 Nicola Global Real Estate Fund, Nicola Canadian Real Estate LP, Nicola U.S. Real Estate LP, and Nicola Value Add LP adopted new mandates and changed names from NWM Real Estate Fund, SPIRE Real Estate LP, SPIRE US LP, SPIRE Value Add LP.