No Recession Ahead, But Expect Slow Growth - Nicola Wealth

No Recession Ahead, But Expect Slow Growth

By Rob Edel, CFA

Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

Returns for the NWM Core Portfolio increased 1.2% for the month of May. NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.

The Canadian yield curve steepened during the month, with 2-year Canada yields decreasing from 0.68% at the beginning of the month to 0.57% at the end of the month, while 10-year Canadas increased from 1.59% to 1.62%.

Both 2-year and 10-year U.S. treasuries increased in May and continued to move higher in early June. NWM Bond performed well in this rising rate environment, and was down only 0.1%.

The PH&N Short Term Bond Fund, which benefited from the decrease in short term Canadian rates, was up 0.3%, and Marret Investment Grade Hedged Strategies Fund and Arrow East Coast Fund were up 0.3% and 0.2% respectively. PR Fixed Income Plus was down 0.6%.

High yield bonds were higher in May, with NWM High Yield Bond up 1.7%. Most of this gain was due to currency as some of our U.S. dollar high bond positions are not hedged back into Canadian dollars.

Same was true for global bonds, with NWM Global Bond up 1.7%. The PIMCO Monthly Income Fund is unhedged and the Templeton Global Income Fund actively manages their foreign currency positions.

The mortgage pools continued to delivered consistent returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.5% respectively in May.

After initially moving higher, the preferred share market drifted lower in the last two weeks of May to end the month down 0.5%, while NWM Preferred Share was flat. Although sentiment is picking up in the space, two factors weighed on preferred shares for the month: a steepening yield curve and wider credit spreads.

Canadian equities were weaker in May, with the S&P/TSX down 1.3% (total return, including dividends). NWM Canadian Equity Income (the former Strategic Income Fund) lost 0.5%, but NWM Canadian Tactical High Income gained 0.6%, thus exhibiting the benefit of an option writing strategy in a down market.

The cash position in NWM Canadian Equity Income is currently just over 4.5% and approximately 5% of our positions are covered. As for NWM Canadian Tactical High Income, we added a new short put position in Alimentation Couche-Tarde and added to our existing positions in Ag Growth, KP Tissue, and Gluskin Sheff.

Foreign equities were positive in May, and while the weaker Canadian dollar helped, most global indices ended the month up in local currency terms.

NWM Global Equity was up 3.7% compared to a 3.5% increase in the MSCI All World Index and a 4.4% rise in the S&P 500 (in Canadian dollar terms). All of our external managers delivered positive returns with Edgepoint leading the way +4.9% followed by Pier 21 Carnegie +4.7%, Lazard Global Small Cap +4.2%, Mackenzie Cundill +2.0%, and BMO Asia Growth & Income +0.8%.

NWM U.S. Equity Income was up 1.8% in U.S. dollar terms and NWM U.S. Tactical High Income gained 0.4% versus a 1.3% increase in the S&P 500. For NWM U.S. Equity Income, we sold our remaining position in Target. The fund has a cash position of 4.6% and 12% of the fund is covered.

For the NWM U.S. Tactical High Income, we were called away on our JPM Alerian MLP ETF position and have not repurchased the position.

Higher interest rates continue to provide a headwind for REIT’s; however, NWM Real Estate is down only 0.1% despite a 5.2% decline in the iShares REIT ETF.

NWM Alternative Strategies was up 1.3% in May (these are estimates and can’t be confirmed until later in the month). Altegris feeder funds Winton, Brevan Howard, Millennium, and Hayman were all positive, increasing 1.9%, 4.1, 4.3%, and 2.2% respectively. Again, a 3.1% decline in the Canadian dollar helped these funds, which use the U.S. dollar as their base currency and do not hedge.

MAM Global Absolute Return Private Pool, RP Debt Opportunities, Polar Multi Strategy, and RBC Multi-Strategy Trust Units were also up in May, increasing 0.9%, 0.5%, 0.9%, and 0.4% respectively. SW8 was the lone alternative fund down in May, losing 18.9%.

We have been invested in SW8 since its inception over 5 years ago. While the fund has struggled over the past couple of months, manager, Matt Skipp, has provided solid performance over the years and we have confidence he will continue to do so in the future.

Having said this, the style of the funds does not align with what we are trying to do longer term in the NWM Alternative Strategies so we have decided to transition out of SW8 over the next few months.

NWM Precious Metals gained 3.5% in May with gold bullion up 3.7% in Canadian dollar terms.

May In Review

Another fine month for stocks in May, with the S&P 500 up 1.3% (in U.S. dollar terms).

Canada, in fact, was one of the few markets to lose ground in May, with the S&P/TSX down 1.3%, mainly due to weak returns in the energy sector.

The S&P/TSX is still up for the year, however, and beating the S&P 500 in local currency terms.

Equities continue to defy the skeptics. Despite hitting new highs, investors have ramped up bets against the S&P 500, as evidenced by the increasing net short positions on the Chicago Mercantile Exchange (aka E-Mini S&P).

Slower economic growth, poor first quarter earnings, and a looming hike in the Federal Funds rate has many investors convinced a pullback is a question of when (and how much), and not if.

06 MMC #1

Not surprisingly given the current bull market is six years old and counting, valuations are also an issue. 

Even Federal Reserve Chair, Janet Yellen, recently commented that stock prices were “quite high”. Based on Robert Shiller’s cyclically adjusted price earnings ratio (CAPE), which uses average earnings over the past ten years as the denominator, U.S. equities are trading at 27 times earning versus a long term average (dating back to 1881) of 16.6 times.

Based on current valuations, Goldman Sachs strategist David Kostin believes investors shouldn’t expect any price gains in the next year, and only an annualized 5% over the next decade, including dividends!

Of course he isn’t the first strategist to forecast the top for equities only to see the market continue to move higher.

06 MMC #2

And Janet Yellen wouldn’t be the first Fed Chair to call the market “expensive” years before the end of a bull market.

In late 1996, then Federal Reserve Chair, Alan Greenspan, made his famous “irrational exuberance” comment, only to see the S&P 500 increase over 33% the next year, and over 28% the year after that.

In fact, the S&P 500 would go on to soar 320% before beginning to roll over in March of 2000.  Oh, and the CAPE at the time Greenspan made his comment was 28 times, on its way to over 40 times.

In fact, Shiller himself admits the CAPE is a poor short term predictor of market returns and there have been several times where the market has traded at similar valuations as today and gone on to deliver 3-year returns of over 20%.

Perhaps keeping this in mind, Yellen’s former boss, Ben Bernanke, believes stocks have only returned to normal valuations, after having been “severely depressed” during the financial crisis.

I guess this is what makes a market.

06 MMC #3

06 MMC #4

Why is Federal Reserve Chair, Janet Yellen, worrying about the stock valuations anyways? The bond market is where the real action is.

Since the beginning of 2014, fund flows have favored bonds over stocks, despite the fact most traders have been betting interest rates would rise in 2015. With the economy continuing to recover and the Federal Reserve eager to start increasing rates, it would seem logical for bond yields to start moving higher.

Even the current strength in the stock market points to higher interest rates. Historically, stocks have shown a positive correlation to higher yields, which makes sense given interest rates should increase if the economy gets stronger — and a stronger economy is good for stocks.

While it is true higher interest rates can also cause stock valuations to contract, this is only usually the case later in the interest rate tightening cycle when higher rates start to slow economic growth.

06 MMC #5

06 MMC #6

Given an increase in interest rates is long overdue, last month’s increase in bond yields (decrease in prices) is not a surprise though the timing is a bit curious. 

When we look at the numbers, it definitely looks like the U.S. economy has slowed and lost a bit of momentum. Last year, when the economy was gaining momentum, yields didn’t go up; in fact, they drifted lower.

But now, when the U.S. economy has hit a soft patch, interest rates head higher?

As was the case last year, it’s not what’s happening with the U.S. economy that’s moving rates, but rather what’s happening in Europe.

Quantitative easing is beginning to work its magic in the Eurozone with economic growth and inflation starting to recover. Yes, Greece’s future in the common currency bloc is still uncertain, but contingencies have been put in place such that the impact of a Grexit could be very manageable.

If the deflation scenario is being taken off the table, ultra-low or even negative bond yields become very unattractive, very quickly. And perhaps this is what has traders most on edge — not just the fact rates moved higher, but the speed and magnitude of the move.

In early June, German 10-year yields jumped nearly 20 basis points in one day — their largest single day increase since at least October 2000. For their part, U.S. 10-year Treasuries backed up 30 basis points in just three trading sessions, their biggest increase since June 2013’s “taper tantrum”.

Of course, volatility is magnified with interest rates so low, but even ECB President, Mario Draghi, recently cautioned investors to get used to higher volatility in the Bond market.

It may seem counterintuitive that interest rates are rising with the ECB actively buying Government bonds (i.e. quantitative easing), but this is what happened in the U.S. as well.

The goal of quantitative easing isn’t to lower interest rates. They are already low enough. It is to increase investor confidence and facilitate economic growth.

Rising interest rates are a sign that this is happening. It’s a good thing.

06 MMC #7

Volatile bond yields aren’t the only thing giving traders headaches. Oil prices have also been tough to predict.

Big hedge funds, in fact, have been so frustrated with oil they have been reducing positions on Brent crude oil futures, both long and short, preferring instead more rational markets like currencies (yes, you are sensing a bit of sarcasm here).

Since bottoming in mid- January, oil has traded in a band between $46 and $68 U.S. per barrel with no discernable trend in place. According to a recent Reuter’s poll, forecasts for crude oil prices over the next year range from a low of $30 to a high of $70 a barrel.

U.S. rig count has been falling, leading many to believe future supply from high cost shale oil will be curtailed. U.S. drillers, however, have successfully driven costs down such that Goldman Sachs now feels most shale-oil plays are economical at $60 a barrel oil — $20 a barrel less than only a year ago, and falling.

With interest rates at record lows, there is plenty of capital available to fund them. Preqin estimates private equity firms alone are on pace to allocate a record $20.6 billion to oil and gas startups in 2015.

And don’t expect supply reductions from OPEC or Russia to help stabilize prices. OPEC production is near record levels, and Russia pumped a post-Soviet high of nearly 11 million barrels a day in May.

With little prospect of anyone proactively cutting supply, increased demand is the only real driver to move prices higher. There are signs that this is happening.

The IEP (International Energy Agency) recently forecast an increase in global demand in 2015 of 1.4 million barrels a day — 300,000 barrels more than their previous estimate — driven partly by a 4.2% increase in U.S. gasoline demand.

But with prices on the rise recently, is this sustainable?

Also, auto demand in China has slowed, as has the Chinese economy. It’s hard to get too excited over oil demand if China isn’t leading the charge forward. If the global economy grows stronger than expected, so will demand for oil. If it doesn’t, oil prices look vulnerable.

The problem is, forecasting economic growth is even tougher than forecasting oil prices. 

06 MMC #8


Case in point, what will China’s GDP growth rate be over the next few years?

Premier Li Keqiang has set a 7% target for 2015, but most believe China’s official growth rate is inflated and real economic growth is actually lower. China could hit the official 7% target, but real growth is anyone’s guess.

Complicating things, China is trying to re-balance their economy towards a more consumption based economy, less dependent on cheap exports and investment. At the same time, China would like the yuan to become a global reserve currency and is slowly opening up its domestic bond market to foreign investors.

Next up is likely increased foreign access to the domestic equity markets, which is probably why Beijing is encouraging Chinese retail investors to buy stocks and front run foreign investors.

As a result, trading in Chinese stocks has skyrocketed and valuations are soaring.

Legendary bond manager, Bill Gross, was recently quoted as saying German Bunds (government bonds) were a short of a lifetime, which, based on recent trading action, has been a good call.  Next up, Gross had tipped Chinese stocks as a big shorting opportunity, though not quite yet.

Tough to short some something that is up nearly 100% year to date and over 23% in May, like the Shenzhen stock exchange, but prices and valuations do not appear to be mirroring what is happening in the real domestic Chinese economy.

A strong stock market can help Chinese companies reduce debt and aid Beijing in consolidating and restructuring China’s more than 100,000 state owned enterprises.

However, we are not aware of any problems that have been solved with a good old fashioned stock market bubble.

06 MMC #9

06 MMC #10

A better European economy and receding deflationary fears means bond yields are heading higher, but not too high. All this is good for stocks, and while market volatility is likely to increase, we don’t see an imminent end to the current bull market.

Slow growth, however, is not good for oil prices and the current rally looks extended. Same goes for Chinese stocks.    

The U.S. Economy06 MMC Table 1

As predicted last month, first quarter U.S. GDP growth was revised lower, indicating the economy contracted 0.7% versus the previously announced +0.2% growth rate. 

A wider than estimated trade deficit was the main culprit, though slower inventory restocking also hurt growth. Confirming the weak trend in the first quarter was weak industrial production, which continues to shrink, and fell for the fifth month in a row in April.

Manufacturing indices were less conclusive, with Chicago contracting while most others pointed towards growth in the manufacturing sector. The San Francisco Federal Reserve is more optimistic and believes economic growth was much higher than reported in Q1, arguing first quarter results were exaggerated by a statistical anomaly.

Rather than a 0.2% increase in GDP (since revised to -0.7%), they believe GDP growth was actually closer to +1.8%. The Commerce Department has indicated they plan to smooth out some “statistical quirks” that could raise fourth and first quarter GDP numbers in the future, but lower the rest of the year.

Recent news flow appears to back up the San Francisco Fed’s suspicions, with more positive news stories on the global economy hitting the wires than negative stories, and at levels consistent with moderate economic growth.

06 MMC #11

That’s not to say, however, that economic growth is robust. Far from it.

At nearly six years old, the economic recovery has already outlasted the post-World War II average in duration, but badly trails in terms of strength.

Given growth has been so weak, averaging a mere 2.2% since the great recession, a negative growth quarter isn’t unusual and shouldn’t be seen as a signal a recession is on its way.

Both Germany and Japan are examples of countries with slow economic growth over the past decade that have experienced the odd negative GDP quarter. With growth so low, the margin of error is slim, making it more likely that routine volatility — like bad weather or a port strike — can push growth into the red.

With the job market continuing to recover and interest rates remaining low, we don’t see a recession in our near future. But we also don’t see strong growth either.

06 MMC #12

06 MMC #13

Population growth and productivity drive economic growth. We have neither, which is why the current economic recovery has been below par.

Population growth has been declining in the developed world for years and is unlikely to help in the foreseeable future. This leaves productivity growth, which had been growing 2.6% per year from 1995 through 2010, but only 0.4% since. And it’s not clear why.

Some hypothesize it’s a reporting issue and there really hasn’t been a decline in productivity growth. By undercounting output growth from things like free internet services, we could be understating productivity.

Some believe the current productivity rut is payback for the outsized productivity gains in 2009 and 2010, when mass layoffs resulted in productivity temporarily spiking while the economy recovered, only to reverse over the last few years as companies re-hire workers as demand recovers.

Certainly part of the problem has also been the lack of capital investment during the recovery.

Companies have been reluctant to invest and expand in plant and equipment. Either because they don’t have confidence in the economy or don’t believe such moves will be rewarded by shareholders, companies are choosing to buy back stock and pay dividends rather than increase capital expenditures.

Globally, capital expenditure is forecast to grow less than 2% over the next year versus 19% in 2011. 

06 MMC #14

06 MMC Table 2


Not only did the U.S. add 280,000 new jobs in May, but March and April’s numbers were revised 32,000 jobs higher. 

The unemployment rate ticked one tenth of a percent higher, but only because more workers entered the work force. The key statistic for the month, however, was wage growth, which rose a higher than expected 2.3% — the highest increase since August 2013.

In the first quarter of 2015, the Bureau of Labor Statistics Employment Cost Index increased 2.6%, the most since 2008, while the Employer Cost for Employee Compensation Index was up 4.9% year over year in March.

The ECEC includes benefits, which are growing faster than wages, and also doesn’t maintain fixed weights for industries like the ECI Index does.

Both the ECI and ECEC confirm the pick-up in wage growth seen in the May payroll report, and the ECEC indicates wage growth is finally reaching levels seen in past economic recoveries.

06 MMC #15

06 MMC #16

06 MMC Table 3

Headline CPI dipped into the red in April but core inflation remained stable at 1.8%.

With oil up almost 30% over the past couple of months and the U.S. dollar weakening, inflation should begin to drift higher over the next few months, as it has already started to do in Europe. Headline CPI dipped into the red in April but core inflation remained stable at 1.8%.

Throw in higher wage growth and we could quickly shift to worrying about inflation versus deflation. 

Admittedly, however, central banks have struggled to correctly predict price increases, consistently overestimating inflation and their ability to hit their 2% target thresholds.

What’s even more concerning for Barclay’s Marvin Barth, about a third of the decline in global inflation over the past decade cannot be explained by traditional drivers like demand or productivity.

He believes 35% of the decline is “hard to pin down” and refers to it as missingflation.  Deleveraging, technological progress, globalization, and demographics are all cited as possible causes, and all are difficult for central banks to control.

It’s hard to have confidence in a central bank’s ability to hit a 2% inflation target if they don’t know why inflation declined in the first place.

06 MMC Table 4

The weakness in the University of Michigan Consumer Confidence Index — which hit a six month low in May — confirms the weakness reported last month in the Conference Board Index, which in turn confirms the recent weakness seen in consumer spending.

The Michigan Index hit an 11-year high in January, however, and is still above levels seen last year and is indicative of a healthy and optimistic consumer.

06 MMC Table 5

OK, winter’s over. It was cold and people stayed indoors and didn’t spend. We get it. So why aren’t they spending now?

Retail spending in April was unchanged from March and up a mere 0.9% year over the year, the smallest 12-month gain since 2009.

Part of the weak spending was a result of lower gas station sales, down 22%, but consumers aren’t spending the money they are saving at the pumps.

The hope is that consumer spending habits take some time to shift and spending should heat up with the weather. We hope so.

Wages are up and jobs are more plentiful, but consumers are saving and paying off debt. 

It’s a bit mysterious, and very un-American!

06 MMC #17

06 MMC Table 6

Existing home sales in April declined versus the previous month, but mainly because the supply of homes available for sale remains tight. As a result, prices continue to move higher, with 40% of transactions in April closing above their initial asking price.

According to S&P Dow Jones, home prices have historically increased 1% a year. Depending on the index, prices are currently increasing anywhere from 4% to nearly 9%. Same goes for the new home market, where sales in April increased at their strongest pace since 2008.

Prices are up over 8% versus last year and currently about 4.2 times a median family’s income, about equal to peak housing bubble levels. Of course the composition of new homes being built has changed, with builders concentrating on the luxury market, thus skewing prices higher.

An increase in construction activity should help, and housing starts are indicating more inventory is on the way. This could be good news for the U.S. economy. 

06 MMC 18

06 MMC #18


06 MMC Table 7

The U.S. trade deficit shrank 19% in April, the most in six years, after ballooning to a six year high in March. 

The resolution of the west coast port strike was cited as a major factor for the volatility in the trade deficit over the last couple of months, and while port traffic should move back to more normal levels, some residual volatility could continue to impact net trade numbers in the near term, making economic growth harder to predict.

06 MMC #19

Wage growth was the big story for the U.S. economy last month. If momentum is maintained, the positive impact from higher salaries will filter down through the whole economy. 

Add to this a recovery in the housing market, and U.S. economic growth will be back on track.

Yes, consumer spending is a little concerning, but we have faith in the American consumers to consume.

The Canadian Economy06 MMC Table 8

Canadian first quarter GDP contracted 0.6%, well below expectations and the worst showing for economic growth since Q2 2009. 

Much of the weakness could be attributed to the slow-down in energy sector, which contracted 1.7% quarter over quarter, though consumer spending was also weaker than expected.

The 0.2% contraction in March GDP indicates the negative impact from oil and gas industry might be more protracted than the Bank of Canada originally hoped and will likely mean full year GDP growth will miss their 1.9% forecast.

Manufacturing, which recovered nicely in March after a very slow start to the year, could provide a partial offset, as much of the weakness seen in the auto sector was transitory in nature.

06 MMC Table 9

While GDP growth surprised to the downside, employment reported a better than expected result in May. 

At nearly 59,000, Canada created the most new jobs in seven months, and its second strongest gain in three years.

The quality was high, with 57,000 of the jobs coming from the private sector, and nearly 31,000 were full-time positions. The unemployment rate was unchanged as more workers entered the job market.

While May’s report is certainly good news, we recognize the volatility of recent releases might indicate this could be reversed in future months, especially given continued weakness in Alberta and the energy sector.

06 MMC Table 10

Inflation moderated in April, mainly due to lower energy prices. The weaker Canadian dollar could help offset some of the future weakness in inflation as the impact of lower oil prices continues to work its way through the economy.

Overall, no inflationary concerns on the horizon.

06 MMC Table 11

Retail sales came in better than expected in March, driven by higher auto prices. While this is good news, it is unlikely enough to offset the contraction in the energy sector and should moderate in future months, given current consumer debt levels.

06 MMC Table 12

Toronto and Vancouver continue to power the Canadian housing market higher. Average home prices were up nearly 10% year over year in April, but only +3.4% excluding Toronto and Vancouver.

Housing starts and building permits remain strong, and with about a 6-month supply of homes available for sale, the market remains balanced between buyers and sellers. 

06 MMC Table 13

Canada’s trade deficit narrowed in April, but less than expected; it’s still the second largest deficit ever.

Most of the decline in imports was due to lower volumes, while the decrease in exports was mainly due to falling prices. A pick up in manufacturing exports as a result of the lower Canadian dollar has so far failed to materialize.

Trade should normalize in the second half of the year and provide some support to GDP growth, but perhaps not as much as originally forecast.

The impact of lower oil prices on the energy industry and high consumer debt levels continue to leave us cautious on the Canadian economy.

A weaker Canadian dollar and stronger U.S. economy should help, but it will take time for the composition of the Canadian economy to adjust in order to take advantage of these factors.

 We have been invested in SW8 since its inception over 5 years ago. While the fund has struggled over the past couple of months, manager, Matt Skipp, has provided solid performance over the years and we have confidence he will continue to do so in the future.

Having said this, the style of the funds does not align with what we are trying to do longer term in the Alternative Strategies fund so we have decided to transition out of SW8 over the next few months.

What did you think of May’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.