Highlights This Month
- Mid-year markets prove most experts wrong
- What were Canada’s best performing sectors in June — and why?
- The results of U.S. fed’s June conference
- European economy stifled by high unemployment and inflation danger
- What is brent oil and how will its rising price impact the U.S. economy?
- What’s behind the “big miss” in G1 estimates
- U.S. employment highlights
- Will higher net worth result in increased consumer spending?
- Bank of Canada key lending rate not expected to rise
- Why the surprise increase in June unemployment?
- Good news for B.C.’s inflation rate
- Home sales peak in largest month-to-month increase since 2010
- The main risks currently threatening a stable housing market
The NWM Portfolio
Measured in Canadian dollars, we had positive performance from 11 out of our 13 NWM Investment Pools last month, with only our foreign assets detracting from performance.
The Canadian dollar appreciated ~1.6% against the greenback during the month of June and is at roughly the same level as at the end of 2013, which was a headwind for some of our pools (e.g. NWM U.S. Tactical High Income).
Up 0.68% in June, NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Investment Pools and Limited Partnerships.
The S&P/TSX was on fire in May up 4.06%. NWM Strategic Income performed well (+2.05%) considering no exposure to gold within this pool; the gold sub-sector was up 17.8%.
On that note, NWM Precious Metals was the best performing pool for the month (+16.5%) and year-to-date (32.51%).
Interest rates moved up slightly higher last month with the 2-year Canadas going from 1.049% to 1.105%. The 10-year Canadas went round trip, starting the month at 2.25%, hitting a high around 2.35%, but then ending the month at 2.24%.
NWM Bond returned 0.28% with positive contributions from all of our managers. NWM Global Bond was down 0.88% due to currency headwinds from the appreciation of the Canadian dollar.
The Canadian preferred share market continues to be on a tear as the iShares S&P/TSX Preferred Share ETF was up 1.05% and the BMO S&P/TSX Laddered Preferred Share Index ETF was up 1.49%. NWM Preferred Share was up a strong 1.48% as spreads ground tighter.
Active participation in the new issuance market has done well for the pool. All seven of the new issues in which we participated that started trading in June are above par now. We expect a further bump up in prices as most of the issues will be announced in the index inclusion list and indexers / ETF’s will continue to chase the price up.
NWM High Yield Bond was up 0.22%. Most of the underlying managers performed well as credit spreads in both Canada and the U.S. tightened during the month, which helped returns. The appreciation of the Canadian dollar hurt our unhedged U.S. dollar exposure.
NWM Primary Mortgage and NWM Balanced Mortgage returned 0.25% & 0.57% respectively. The S&P/TSX Capped REIT Index was up a solid 0.96%. NWM Real Estate was up a respectable 0.30%.
NWM Canadian Tactical High Income was up 1.88% for the month and 7.27% on the year. In terms of managing the collateral being used to back the “put” options, earlier this month we reduced our high yield bond exposure down to ~8.5% and added a new position in NWM Balanced Mortgage.
NWM Global Equity was down 0.58% in June versus a 0.19% gain for the MSCI World ACWI Index.
NWM U.S. Tactical High Income returned 0.52% (-1.1% CDN$) vs. 2.07% for the S&P 500. The current estimated annualized yield on the pool is ~11.60%.
NWM Alternative Strategies returned -1% in June (this is an estimate and can’t be confirmed until later this month).
June in Review
“If you’re a bull and you’re wrong, you’re forgiven. If you’re a bull and you’re right, they love you. If you’re a bear and you’re right, you’re respected. If you’re a bear and you’re wrong, you’re fired.”
Tobias Levkovich (Chief U.S. Equity Strategist)
We are at the mid-point of the year and all major global markets are performing much better than most experts had predicted. This shouldn’t come as a surprise as market prognosticators have a knack of being way off the mark.
Remember back at the end of 2012 when market gurus were calling for a substantial slowdown in economic growth for 2013 due to the fiscal cliff (payroll tax hikes, budget sequestrations, tax increases, etc.) and the prospect of another political circus raising the debt ceiling?
Back then, very smart and well known investors such as Mario Gabelli (GAMCO Investors) and Jeff Gundlach (DoubleLine Capital) were not too keen on the U.S. equity market future returns.
Gabelli predicted that the U.S. markets would produce returns of no higher than 5%. Gundlach recommended that investors sell U.S. stocks and buy Chinese stocks. How did that turn out?
Well, that year the S&P 500 returned its best performance since 1997 (+32.4%) despite the U.S. political sideshow, the unrest in Syria, the Boston Marathon bombings, and the jump in yields on long-term bonds to their highest level since July 2011 (the bond market suffered their worst loss since 1994).
On the other hand, the Shanghai Composite returned -3.80%.
At the end of 2013, forecasters also predicted that the 10-year U.S. treasury could go up to 3.5% as the Fed began to reducing their monetary stimulus due to an improving economy.
Well, so far they are batting 0.500 – the economy is improving, but the 10-year yield dropped sharply and closed this month sub-2.60%.
Every year there is a war, a catastrophe, or some other market-moving event that you just cannot predict.
Trying to time the markets by following market pundits’ advice can be financially and emotionally painful, as shown in the following data compiled by JP Morgan Asset Management:
- An investor that stayed fully invested in the S&P 500 from 1993 to 2013 would have had a 9.2% annualized return.
- Missing just the 10 best days would reduce the return from 9.2% to 5.4%; this would have resulted in a 50% reduction in the value of your portfolio vs. staying fully invested.
Instead of putting all of your proverbial eggs in one basket based on one big macro bet and/or trying to “time the market,” it has always made sense to us to be fully invested in a well-diversified portfolio with a bias towards cash-flow, since cash flow tends to be more predictable.
Okay, enough about market timing and predictions; let’s talk about what happened last month.
The S&P/TSX was up 4.06% for the month of June and 12.85% year-to-date.
To put this number into perspective, 2013’s total return for the whole year was 12.96%. Last time we had numbers this good we were coming out of the recession in 2009 when the first six months of the year returned 17.53%!
The best performing sectors for the month were Energy (+5.5%) and Materials (+10.3%) – the gold sub-sector alone was up 17.8%. Energy and Materials were also the biggest gainers year-to-date returning 21.1% & 16.6% respectively.
The combination of geopolitical events, flare-ups, and currency debasement is always a good recipe for gold and oil.
In terms of valuation, the S&P/TSX was trading at ~16.5x estimated forward earnings (3-year high), which is a bit higher than the 10-year average of 15.2x.
The Fed held a press conference on June 18th to discuss their views on the economy, interest rates and stimulus. As expected, they cut their monthly bond purchases by another $10-billion per month and will continue to keep the Fed Funds Rate at near zero.
There was a lot of talk about the Fed’s “dots” by market watchers. What exactly are these “dots” and what do they mean?
Well, the dots represent each Fed member’s best forecast (guess) of where interest rates should be based on each of the 16 members’ economic views. The most recent “dot plot” shows that all Committee Members except one (there’s always one) expect rates to stay the same in 2014.
2015, however, is a different story. Committee members think that rates may reach 1%-1.25%. St. Louis Fed President James Bullard is more aggressive in his predictions than his colleagues and expects rates to start increasing in the first quarter of 2015.
The markets don’t seem too concerned about the near-term prospects of rising rates as the S&P 500’s response following the Federal Open Market Committee (FOMC) conference was to set new record highs.
Even the volatile NASDAQ reached its highest level in 14 years. Clearly the equity markets are still the hot game in town while the punchbowl is still full of Fed juice.
For the month of June, the S&P 500 continued to grind higher gaining 2.06% (led by Energy: +4.9%) and up 7.12% year-to-date (led by Utilities – not a typo, they were up 16.4%).
After last year’s 32%+ gain, the S&P 500 has taken a little bit of a breather relative to its northern neighbour.
In terms of valuation, the S&P 500 looks a bit rich when looking at both the Shiller price-to-earnings ratio (10-year inflation-adjusted earnings) and the 12-month forward price-to-earnings ratio (25.6x & 15.6x respectively) as both are above their long-term averages of 22.9x & 13.8x respectively.
Their economy continues to struggle with stubbornly high unemployment (11.6%), a slowdown in manufacturing and low inflation of 0.50%. The ECB is extremely worried about inflation under 1% and calls it the “danger zone.”
Earlier in the month ECB’s Mario Draghi was back in action announcing a fresh package of stimulus measures which included bringing the deposit rate into negative territory (0.10%) and cutting the benchmark rate from 0.25% to 0.15%.
After the announcement, the Euro started to fall. Draghi and his fellow policy makers had been concerned about the strength of the Euro and have welcomed a falling currency as this helps prevent deflation and will help out the Euro-zone exporters.
The Euro-zone economy is still fragile – the World Bank sees the Euro region expanding just 1.1%, versus 2.8% for the rest of the world.
Russia and Ukraine
Russia’s Gazprom stopped supplying gas to the Ukraine after a dispute over gas price hikes and the $4.5-billion debt Ukraine owes for past gas deliveries.
This won’t affect the Ukraine right now, but could be an issue in the winter. Flows to the rest of Europe via the Ukraine remains unaffected at the moment unless the Ukraine starts to siphon off gas again like they allegedly did back in 2009.
The 10-day cease-fire ended on July 1 and fighting continued as both sides failed to reached an agreement. Talks appear to have stalled with the Kiev Government remaining steadfast in keeping security forces in eastern Ukraine.
Iraq is the second biggest producer in OPEC (Organization for Petroleum Exporting Countries), accounting for 10% of output (or ~3.3 million barrels per day) and ~60% of future growth.
The Islamic State of Iraq and the Levant (ISIL) has caused chaos in northern Iraq by damaging a key oil pipeline and effectively shutting down the Baiji refinery (Iraq’s largest).
So far the fighting has been largely isolated to central and northern Iraq and not down south where greater than 75% of Iraq’s crude oil production comes from.
A $10 sustained increase in Brent Oil prices knocks 0.4% from GDP growth four quarters out and raises CPI by ~1%. A $50 shock is enough to stall the U.S. economy; the higher price is a hidden tax on consumers.
If we were to see a loss of half of Iraq’s oil supply we could be retesting a milestone set in July 2008 when Brent Oil was trading at $140 (world gasoline prices trade off Brent) and gasoline prices were $4.11/gallon. If this happens we should expect to see a negative reaction by consumers.
Can America save the day with the rebirth of their oil industry?
In the short-term the answer is no. The U.S. has been a net importer for crude oil since the 1940s and they still import roughly 1/3 of their oil needs.
The U.S. is not expected to become “energy independent” until at least 2020.
In addition, the Gulf Coast refineries are mostly suited to heavy crude (think Mexico and Venezuela heavy crude); therefore, the abundance of the light sweet crude is not really helping.
This light sweet crude could be shipped to the east coast refineries, but it would cost ~$3-$5/barrel more to do so due to the Jones Act restrictions (where America can only use U.S. tankers, which are limited in availability), making it cheaper to ship it to East Coast Canadian refineries by rail.
Since late June, Brent Oil prices have been coming back down as Iraq’s crude oil production remained unaffected by violence and news of Libya preparing to resume exports. Let’s hope this continues.
Let’s now recap the economic data in both the U.S. and Canada.
The U.S. Economy
The final (third estimate) Q1 real GDP numbers came out late this month and were much worse than expected. The -2.9% annualized quarter-over-quarter drop was the fastest rate of decline since mid-2009.
Their first estimate had GDP growing at a 0.1% annualized rate; their second estimate showed GDP contracted at 1%; and now this -2.9% figure.
The big miss in estimates (largest since 1976) can be attributable to a smaller than expected increase in personal consumption, large drawdown in business inventories and steep drop off in exports.
Healthcare declined at a -1.4% annualized rate vs. previous estimates for a 9.1% increase. This was mainly due to overestimating the spending amounts from the Affordable Care Act enrollments and Medicaid data.
Overestimating GDP growth is nothing new for the FOMC. The 16 members of the FOMC are an optimistic bunch despite recently lowering their 2014 GDP growth range from 2.8%-3.0% to 2.1%-2.3%.
They estimate GDP to grow 3% in 2015. The late economist John Kenneth Galbraith got it right when he said “the purpose of economic forecasting is to make astrology look respectable.”
The U.S. should follow China’s reporting system: post the GDP figure only once and that’s it; move on, no revisions. In fact, Markit Economics only posts the PMI numbers once as well.
Anyway, the bad weather story in Q1 is history and the Q2 underlying trends have shown improvement with the Manufacturing PMI (expanded at its fastest rate in four years) and ISM surveys clearly in expansionary territory.
We’ll have to wait until July 30th when the Q2 GDP advanced estimate is released.
- June’s non-farm payroll increased to 288,000 jobs; this is the 5th month in a row with over 200,000 new jobs.
- Both April and May’s jobs numbers were revised higher; 2014 is now averaging 231,000 jobs/month.
- Widespread hiring across the board (hospitality, manufacturing, professional, retail, government and healthcare)
- The unemployment rate is now at 6.1%; best since September 2008.
- The unemployment rate including unemployed, involuntary part-time, marginally attached, and discouraged workers dropped 0.1% to 12.1% – but still much higher than the 8.8% average pre-recession.
- Long-term unemployed down 293,000 to 3.1 million.
- Average hourly earnings increase 0.20% over the prior month.
- The participation rate is stuck at 62.8%; the lowest since 1978.
- Most major worker groups saw flat to slight decreases in unemployment, except for teenagers; the rate of unemployment for teenagers is 21% (this is bad news for The Bank of Mom and Dad).
- The number of involuntary part-time workers increased in June to 7.5 million; this could be due to companies reducing the amount of full-time staff (to less than 50%) and hours worked (less than 30 hours) to side-step Obamacare’s rules by hiring more part-timers.
The cartoon below depicts how some market watchers look at the headline employment numbers without digging into the details.
May’s Headline CPI was higher than estimates, increasing 0.4% for the biggest advance since February. Prices were higher across the board with Energy leading the way.
On a year-over-year basis, the 2.1% CPI increase was the highest since October 2012.
The Personal Consumption Expenditures Price Index (PCE), the Fed’s favourite inflation measure, was also up; the most since October, posting a 1.8% increase from a year earlier.
This is still below the Fed’s target of 2%, but it is heading in the right direction. It appears that the Fed is comfortable overshooting the 2%, which is causing some market watchers to think that the Fed will be behind the curve when inflation starts to gain traction.
We are seeing evidence of price inputs increasing at the manufacturing level as shown by the recent Philly Fed Manufacturing Prices Paid Index. This Prices Paid Index is up significantly over last month.
You may wonder why the Fed chooses to use PCE instead of the more talked about CPI. The Fed made the switch to PCE from CPI in 2000. One of the main advantages of PCE over CPI is the substitution effects from changes in consumer behavior to prices vs. CPI, which is a fixed basket of goods and services.
You’ll notice in the chart below the biggest difference in weightings is in shelter/housing. PCE is 15% vs. CPI at 31%.
Now that we’ve got that sorted out, look at the chart below and you tell me if the government’s inflation numbers are detached from reality. I guess I could substitute items and maybe live in a tent, walk to work and eat cat food, but I don’t think I can sell this idea to my family.
Consumers are feeling more positive in their short-term expectations with regards to employment opportunities and the direction of the economy. In fact, the Consumer Confidence Index is now at its highest level since January 2008.
Even though the stock markets are hitting new record highs, property values are increasing and the employment situation is improving, there is still some concern about rising energy and food costs; especially since wage growth is barely keeping up with inflation.
The key indicator to watch is the University of Michigan Confidence survey, which is a high frequency survey that is very sensitive to gas prices. Sustained higher gas prices will take a bite out of the consumer’s wallet and lower consumer confidence.
Thanks to the Fed’s ultra-loose monetary policies, Americans’ wealth hit a new record of just over $80-trillion.
Real estate and stocks have bounced back from the depths of the recession. With net worth at new highs, this should result in more spending, right?
Not necessarily. As the wealth increase has not been evenly distributed, it has been the rich that have been getting richer and there are only so many yachts you can buy.
In general, consumers are starting to feel more confident about their personal balance sheets and the economy. This didn’t translate into more spending, though, as May retail sales numbers came in a bit light (0.3%) – nevertheless, still positive and the fourth consecutive monthly gain in sales.
The sales increase was not broad-based with only 6 of the 13 retail categories showing gains. The strongest gains came from auto dealers and building materials. Auto sales alone reached a 16.7 million annual rate which is a post-recession high. Take the auto sector out, however, and May sales would have only increased by 0.1%.
In terms of personal income and personal spending, the numbers came in less robust (personal income was up 0.4%, but spending was only 0.2%). If you adjust for inflation, real consumer spending was actually -0.1%. It appears that the consumer was in saving mode last month as the savings rate is now running at 4.8%.
The banks and credit card companies are trying to do their part to spur spending as they have increased the number of subprime credit cards being issued as well as extending the credit limits of customers with weak credit scores.
Okay, they may be doing this more for their self-interest since the mortgage refinancing wave is over and they need to find more avenues for growth.
We would expect consumers to start letting go of the purse strings as wage growth continues to improve and as food and energy costs stabilize or decline.
U.S. housing continues to shows positive momentum with existing home sales in the month of May rising 4.9% over the previous month – the highest monthly increase since August 2011.
The seasonally adjusted annual rate of 4.89 million is solid, but still below last year’s 5.15 million level during the same month.
New home sales were even more impressive by increasing 18.6%, the biggest monthly gain since 1992.
We can attribute the increase in home sales to a decline in mortgage rates, rising inventory, and improvement in the job market.
The market remains well balanced with 2.28M existing homes available for sale or ~5.6 months of supply.
In terms of prices, the median existing home price in the month of May was $213,400, up 5.1% year-over-year.
The S&P/Case Shiller 20-City Index posted a 10.8% annual gain for the month of April. A few cities stood out in this report. Specifically San Francisco, which rose 2.3% for its 6th consecutive price increase, and Boston, which rose 2.9% for its largest monthly gain in 27 years.
In the next few months, we expect to see a continued pick-up in home sales given that pending sales in May was the largest monthly gain in 4 years. Pending sales tend to show up in home sales numbers when they close in a month or two.
We are still concerned with the affordability and access to credit for first-time home buyers, which represented ~27% of May’s existing sales.
Potential first-time homebuyers tend have high levels of student debt, weak credit scores, little means for down payment, low paying jobs and have to compete with all-cash buyers in a relatively tight market.
If rents continue to increase over the next couple of years because of tight availability, we may start to see more renters become first time home buyers; especially if underwriting standards become more relaxed, wage growth continues to increase and 30-year mortgage rates remain in the sub 4.50% level (currently at 4.14%).
Overall, the U.S. economy continues to show improvements in employment, housing and consumer net worth. The Fed will most likely react slower than most people expect in terms of raising interest rates, as they still see pockets of weakness in the labour and housing markets.
The Canadian Economy
The first data point into second quarter GDP was weak coming in at 0.1% in April—same as March. The weakness came from declines in mining, construction and utilities which were offset by the strength in manufacturing (fourth consecutive increase) and the service industries.
While the Canadian economy has been struggling to put up growth numbers, we are optimistic that the rest of Q2 will play catch-up — maybe not to the 2.5% pace that the Bank of Canada predicted a few months ago, but could be at a 2%+ pace.
At the July 16 meeting, we do not expect Bank of Canada’s (BoC) Governor Stephen Poloz to change the key lending rate of 1% (it has been stuck at this level for 31 straight meetings since September 2010) as the economy is still a bit soft.
That being said, we did see a report in early July showing June’s Purchasing Managers Index numbers – output and new business growth did show strength (6-month high). Let’s see if this trend continues.
On the bright side, most of the jobs lost were part-time and not full-time. In fact, full-time employment rose by 33,500 jobs.
Another positive data point coming out of the report is that wage growth grew by 1.9% year-over-year with the strongest growth coming from the 15-24 year-old demographic (+3.2%).
Although June employment looked a bit disappointing, we take comfort that permanent employment continues to grow.
Inflation was strong again this month. In May, prices rose in all the major components with energy leading the way (+8.4%) and natural gas prices surging 21.3% year-over-year.
The other notable price increases came from shelter, transportation and food (meat and vegetables alone were up 8% and 8.5% respectively).
Core inflation is running at 1.7% and is not expected to reach 2% until the first quarter of 2016; we’ll see how the BoC changes its language around inflation at the next meeting or if they continue with their “higher energy costs being transitory” message.
Consumers started shopping again after the cold winter. April’s retail sales rose faster than expected, growing 1.1% in April and 5.1% year-over-year. The big gains came from automobiles and food. The retailers that struggled the most were the ones involved in selling jewelry, luggage and leather goods.
A lot of this increase was due to the pent-up demand from this year’s brutal winter where potential homebuyers put off purchases and homebuilders saw their biggest quarterly decline since the recession.
Home building rebounded in May to the strongest level in seven months and homebuyers started closing deals.
Despite the sales uplift in May, the combined sales over the past three months are still close to the 10-year average of ~120,000 units.
In terms of house pricing, the national average price for homes sold in May was $416,584 — an increase of 7.1% from last year; however, if you exclude Greater Vancouver and Greater Toronto, the average price would be $336,373 (+5.3%).
The largest year-over-year price growth came from Calgary (+10.12%), Greater Toronto (+7.08%) and Greater Vancouver (+4.27%).
Housing continues to rise despite the government trying its best to try and slow it down by tightening mortgages rules.
BoC Governor Stephen Poloz said earlier this month that the main domestic risk in Canada is the stretched valuations and some signs of overbuilding. I do not disagree with him, but the housing market disagrees and continues to keep moving up.
Overall, Canada’s economy was mixed last month with positives coming from a robust pick-up in the housing market, strong retail sales, and strength in manufacturing. It was countered by higher inflation and weak employment numbers.
Let us know your thoughts on June’s market activity 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.