Nowhere to Hide - Nicola Wealth

Nowhere to Hide


Headlines This Month

NWM Asset Class Highlights

It was a risk off month in June with both fixed income and equity assets trading lower.

Bond yields spiked higher during the month, driving prices lower. The DEX Universe Bond Index dropped 2.03% in June; the NWM Bond Fund was down only 0.60%.

Our short-duration strategy helped mitigate the carnage. Also helping were our recent allocations to alternative investment grade managers Eastcoast, Merrit, and RP, whose performance ranged from -0.20% to -0.40%.

Our alternative managers typically take very little interest rate risk in their portfolios while targeting mid-single digit investment returns through exposure to credit risk. Because fixed income investors chose to flee all bonds in June, credit spreads did widen during the month.

We are still happy with the relative results of these funds in June, but we expect positive absolute returns going forward.

Global bonds did a bit better, with the NWM Global Bond Fund declining only 1.0%. This fund is also positioned to hold very little interest rate risk. Unfortunately, a correction in emerging market debt in June hurt results.

Mortgages were the one fixed income asset class that was able to deliver positive returns with the NWM Primary Mortgage and the NWM Balanced Mortgage Funds returning 0.1% and 0.5% respectively.

Current yields (what the funds would return if all present mortgages were held to maturity and all interest and principal were repaid – this in no way predicts future performance) are 4.5% for the Primary fund and 7.0% for the Balanced.

With the spike in yields and the longer duration nature of preferred shares, the overall market sold off. The Canadian Preferred Universe Index returned -2.6% for the month with few places to hide from the downturn. The NWM Preferred Share Fund significantly outperformed the overall market, but was still down 1.9%.

Canadian equities were down in June with the S&P/TSX losing 3.8% (total return, including dividends), while the NWM Strategic Income Fund (SIF) fared better, only down 1.4%.

June In Review

By Rob Edel, CFA

Stocks and bonds sold off in unison in June after Federal Reserve chairman Ben Bernanke detailed plans to “taper” the Fed’s bond buying program this year and completely end the program by mid-2014.

Bernanke was careful in stressing the announcement was not a change in policy and was dependent on the economic recovery continuing to unfold as expected with unemployment falling to 7%.

Bernanke also reiterated the Fed’s intention to keep short-term interest rates unchanged until unemployment falls to 6.5%, which the Fed doesn’t expect to happen before 2015.

This is what he said. What the market heard was: “party’s over, rates are going up.”

Over the next four days, the S&P 500 fell 4.8% while the U.S. 10-year treasury yields soared from 2.19% to 2.54%. For the month, the S&P 500 and Dow Jones Industrial Average fell 1.3%, while the S&P/TSX continued to underperform, decreasing 3.8%.

MMC-2013-06-Chain Reaction

Clearly, this is not what the Federal Reserve had in mind and the sell-off in the bond market has got to be concerning.

Bernanke and the Fed were probably happy to see some of the froth come off the equity market, but if interest rates rise too much too soon, the economy risks falling back into recession. After all, while the U.S. economy has been showing some positive signs of recovery, growth has been marginal at best so far this year.

The problem is that interest rates are artificially low and everyone knows it. Traditionally, 10-year treasury yields should trade 1.5-2.0% above the inflation rate, which would translate to about 3%. Another industry rule of thumb maintains yields should track economic growth.

If the U.S. is able to muster 3% real GDP growth and 2% inflation, 10-year bond yields could climb back up to 5%.

Either way, rates are nowhere near normal, even after last month’s sell off. And herein lies the problem, even if the Fed would like to see interest rates normalize slowly, investors are likely to react very quickly.

Just ask bond guru Bill Gross, manager of the world’s largest bond fund. Investors pulled a record $10-billion from Mr. Gross’ Total Return Bond Fund in June after the fund fell 3.6% in Q2, its largest loss since its 1987 inception.

MMC-2013-06-Blasted

While the sell-off in the bond market was very abrupt, it was not without precedent. According to BMO economists Douglas Porter and Robert Kavcic, during the 30-year bond bull market, there have been seven episodes where rates have risen by 125 basis points in less than a year.

Since last summer, 10-year yields are up only 122 basis points, though it is true 100 of those have come in just the last two months. What is different about this sell-off is commodity prices have also fallen, where in the past seven corrections they have surged materially higher.

Same for equity prices; in five of the seven previous bond corrections, equities moved higher – an average of 9% in fact. This time, the S&P 500 is off about 6% since mid-May.

Why the difference? Well, GDP grew an average 4% in the previous seven scenarios, while full year estimates for 2013 indicate the U.S. economy will be lucky to break the 2% mark.

Even worse for the equity markets, earning estimates are starting to trend lower with Citigroup recently highlighting 6.5 negative earnings pre-announcements for every positive one, the highest ratio since 2009.

U.S. companies get almost 22% of their profits overseas, where economic growth is looking even worse than in America. While investors would normally be tempted to hide in defensive sectors of the market in order to avoid volatility, it’s not certain what is defensive in today’s market.

Traditionally defensive sectors such as consumer staples (think Proctor & Gamble and Coke) have rallied more than the broader market this year, and according to Credit Suisse, are expensive relative to stocks in cyclical sectors.

Accordingly, defensive names actually pulled back more during the latest market correction. It’s tough out there!

MMC-2013-06-Earnings Slowdown

MMC-2013-06-Safety Hazard

Where can an investor turn to protect capital and get a decent return?

Well, how about China and the emerging markets? They have stronger economic growth and lower debt burdens.

So why have emerging market equities been underperforming those of the developed markets? Or more specifically, why has the Shanghai composite underperformed the S&P 500? Because while growth in China is still quite high, it is decelerating rapidly.

Chinese GDP grew 7.7% in Q1 and forecasters are estimating 7.5% growth in Q2. According to the HSBC purchasing manager’s index, manufacturing is actually contracting.

Goldman Sachs points out that China’s economic growth has been fueled by an aggressive investment cycle that has resulted in serious over capacity and inefficiency, not to mention a worrisome increase in private and local government debt.

Capital investment comprised 47% of GDP last year and a return to more normal levels of 40% could result in GDP growth falling to 4.5% by 2020.

MMC-2013-06-Slowing Down

Perhaps Japan is finally the place to put one’s hard earned savings? Japanese equities were up a mind blowing 80% in six months due to hopes Prime Minister Abe was going to awaken Japan from its deflationary slumber.

The World Bank, in fact, recently doubled its full year forecast for Japanese GDP growth to 1.4% while cutting estimates for China and Europe. Unfortunately, it is not a sure thing that Abe will be successful.

A recent Wall Street Journal survey found over 83% of economists responding were concerned about Japan’s government debt burden and, as a group, believe Japanese GDP will achieve an annual growth rate of only 1.33% over the next 10 years, well below Abe’s 2% target.

After reaching its highs for the year on May 22 – up over 50% – the Nikkei proceeded to fall over 20% the next three weeks, price action which is typically considered that of a bear market. While the Nikkei has subsequently re-captured nearly half of these losses, Japan is anything but a safe bet.

MMC-2013-06-Japan's New Bear Market

So that leaves Europe. In some ways, Europe is the opposite of China. China’s economic growth has been so strong, it has nowhere to go but down. In Europe, economic growth has been so bad, it can only get better.

Europe avoided much of the volatility in June because it was already a basket case. Well, that’s one way of looking at it anyway. To be fair, economic conditions are less bad in Europe with GDP continuing to contract, but at a slower rate.

The Euro has benefited from the Federal Reserve’s pledge to “taper” their bond buying, as investors retreated from the liquidity-fed emerging markets and sought safety in the more heavily traded Euro, U.S. dollar, and Japanese Yen.

MMC-2013-06-Smooth Sailing

Not to disappoint, however, political turmoil in Portugal and Greece put traders on edge in early July as austerity continues to create friction with the voting public in the peripheral countries.

While the economy in the Euro Zone may find its footing over the next several quarters, Europe continues to be just one slip away from another crisis as its structural problems remain unsolved.
Opinion polls indicate no Euro Zone country wants to leave the Euro, but there is a growing distrust of the European Union and its benefits.

Europe needs to move closer to political union in order for the Euro to survive in the long term, yet European support for EU institutions is actually declining. Most Europeans now believe Europe integration has actually weakened their national economy.

MMC-2013-06-Losing Confidence

Overall, the U.S. continues to look like the “least dirty shirt” in the global laundry bin. The Fed has intimated that they will begin easing monetary stimulus if the economy continues to improve, but as we note below, the Fed is more optimistic than most in regards to growth.

If they are right, they tighten but the economy is stronger; if they are wrong, they keep buying bonds. Either way the market should be happy. It just doesn’t know it yet.

The U.S. Economy

MMC-2013-06-Economic Growth-Table-US

First quarter GDP growth was revised down to a mere 1.8% versus previous estimates of 2.4% growth as consumer spending and business investment estimates were trimmed. Manufacturing indicators, though mixed, were certainly better than in Europe or Asia.

MMC-2013-06-Mixed Readings for Manufacturers

Leading the way was the auto industry, which contributed about half the 1.8% increase in GDP in Q1.

Since bottoming in 2009, the auto sector has re-invented itself and is on track to produce over 15 million vehicles in 2013 versus 10.4 million in 2009. A resurgent construction and energy sector has helped with demand, especially for pickup trucks. Record low interest rates don’t hurt either.

But it is more than stronger domestic demand that is driving the industry. Lower wage costs and the closure of unproductive production facilities have made U.S. factories more competitive.

The average cost for a U.S. auto worker in 2011 was $38 an hour, up only $3 per hour since 2007. In Japan, workers make $37 an hour, up $12 per hour, while German workers take home $60 an hour, $14 per hour higher than in 2007.

Not surprisingly, many foreign companies are beginning to produce more cars in the U.S..  Honda, in fact, predicts that by 2014, they will be exporting more cars from North America than they do from Japan.

MMC-2013-06-June Sales Sizzle

While the rebound in the auto industry is encouraging, it still makes up about only 4% of U.S. GDP.

If interest rates continue to move higher, consumers might pull back spending on not only cars, but housing as well. A Wall Street Journal survey found forecasters expect GDP to grow 2.3% in 2013 and 2.8% next year.

The IMF is more pessimistic, estimating GDP will advance only 1.7% this year and 2.7% in 2014. On the more optimistic side, the Federal Reserve believes GDP will grow 2.6% in 2013 and 3.2% in 2014.

The White House thinks GDP can increase 2.4% this year, but then they also believe the sequestration budget cuts will be cancelled and replaced with a package that will reduce the budget deficit gradually over a period of time.

Don’t trust the White House estimates. They are probably based more on politics than sound economic forecasting principles. As for the Fed, their forecasting track record is poor. Economic growth is likely to disappoint and thus interest rates could trade lower in the near term as the Fed keeps buying bonds.

MMC-2013-06-Rose-Colored Glasses

MMC-2013-06-Employment-Table-US

A very good month for the job market in June. Not only were 195,000 new jobs created, but April and May’s gains were revised a cumulative 70,000 jobs higher.

The U.S. has averaged 196,000 new jobs per month over the past 3 months and 202,000 over the past 6 months. The unemployment was unchanged at 7.6%, but only because 177,000 new workers entered the labour force. Wages increased marginally, as well as hours worked.

Gains were concentrated in the business services sector (+53,000), retail (+37,000), finance (+17,000) and construction (+13,000). The manufacturing sector contracted for the fourth straight month, losing 7,000 jobs, while the public sector lost 5,000 jobs.

MMC-2013-06-Job growth is slow but steady

Of course there are always some negatives one can find in any economic report, and last month’s jobs report is no exception.

While the unemployment rate was unchanged, the underemployment rate (which includes those who are working part time even though they want to be working full time and workers who have given up looking all together) increased from 13.8% in May to 14.3% in June.

Even worse, Gallup believes this number is actually 17.2%, and while it is down from its March 2010 peak of 20.3%, it has increased from its recent low of 15.9% in October 2012. The implication of this is that the quality of jobs being created in the U.S. is not that great.

Year to date, 239,000 minimum wage bar and restaurant jobs have been added versus only 13,000 manufacturing jobs. In June alone, the U.S. created 51,700 bar and restaurant workers for a record total of 10,339,800.

Interestingly, if the bulk of the jobs the U.S is creating are low paying and wage growth moved higher in June, what would happen to wage growth if higher paying jobs finally increase in demand?

No worries, we see no signs of this happening in the near future.

MMC-2013-06-Restaurant vs Manufacturing

MMC-2013-06-Inflation-Table-US

While we, and most economists and investors, continue to keep a vigilant eye open for any signs of inflation, so far there is none to be found. If anything, inflation expectations are drifting lower.

MMC-2013-06-Diminished Expectations

MMC-2013-06-Consumer Confidence-Table-US

Consumer confidence remains on the upswing.

MMC-2013-06-University of Michigan Consumer Sentiment

MMC-2013-06-The Consumer-Table-US

Despite higher taxes and modest job growth, consumer spending continues to move higher. As discussed above, cars and housing-related goods are where most of the dollars are going. Having said this, a sharp increase in revolving credit in May points to higher credit card usage.

If this trend were maintained, which hasn’t been the case of late, we could see more retailers begin to benefit. Either the consumer deleveraging cycle is coming to a close, or it is just taking a bit of a summer holiday. This is positive for the U.S. economy.

MMC-2013-06-Retail Rebound

MMC-2013-06-Housing-Table-US

The housing market continues to recover, with sales and prices remaining strong in May. Higher interest rates are a concern, but even with the latest increase bringing mortgage rates above 4%, they are still more than fair.

Goldman Sachs believes even if rates hit 6%, they would still be affordable. Freddie Mac economists estimate that most parts of the country would still be affordable even if rates hit 7%.

The bigger issue right now is the lack of supply on the market and the impact it’s having on prices. Realtors Group economist Lawrence Yun warns that construction needs to increase 50% “very quickly,” but that’s easier said than done.

According to the Bureau of Labor Statistics, from peak to trough, the home building workforce declined almost 43%, shedding nearly 1.5 million jobs. Most of these workers have moved on to other industries, notably the energy sector.

It will take time to ramp construction back up to more normal levels.

MMC-2013-06-Housing's New Hurdle

MMC-2013-06-Trade-Table-US

The U.S. trade deficit widened in May as the slowing global economy weighed on U.S. exports. Conversely, a stronger domestic economy has resulted in non-petroleum exports increasing 2.6%.

It appears the U.S. consumer has once again become the engine of growth for the global economy. Let’s all hope they are up to the task!

MMC-2013-06-Shifting Into a Slightly Higher Gear

If they aren’t, one thing the U.S. economy has going for it is that it relies on trade less than most other large economies. Only 10% of U.S. GDP comes from exports versus 26% for China and 41% for Germany.

MMC-2013-06-The Importance of Exports

The Canadian Economy

MMC-2013-06-Economic Growth-Table-CAD

Canadian GDP growth in April was below current trends, indicating Q2 GDP growth is likely to fall short of Q1’s healthy 2.5% increase. The IMF estimates Canadian GDP should increase 1.7% for 2013 and 2.2% next year.

The Bank of Canada is a bit more optimistic, forecasting a 2.8% increase in 2014. A slowing housing market will provide a headwind for the Canadian economy, but an improving U.S. economy should more than compensate.

Like the rest of the world, Canada will be looking to the U.S. for leadership.

MMC-2013-06-Employment-Table-CAD

Following May’s blockbuster month, a 400 job increase in June was better than expected. Over the past 6 months, Canada has averaged about 14,000 new jobs a month, in line with modest economic growth.

MMC-2013-06-Inflation-Table-CAD

Like the U.S., there are no signs of inflation in Canada. Only alcoholic beverages and tobacco increased more than 2% (up 2.5%) with even food prices up only 1.3%.

MMC-2013-06-Consumer Confidence-Table-CAD

MMC-2013-06-The Consumer-Table-CAD

Retail sales were up marginally due to strong motor vehicle sales (+1.4%). Volumes were up a more inspiring 0.5%.

Stronger consumer confidence should translate into improved retail activity in Q2, though the increase will likely be modest at best. Canadians need to start deleveraging.

MMC-2013-06-Housing-Table-CAD

Predictions of the imminent demise of the Canadian housing market are looking a tad premature and the soft landing scenario is proving more likely. Existing home sales increased in May versus April and were down only 2.6% versus the previous year.

Prices remain firm and inventories appear balanced. Even Vancouver looks to have regained its footing with sales in May increasing 1% from the previous year and breaking a 19 month losing streak.

Sales in June increased nearly 12%, the biggest increase in two years. Still, June sales were 22% below the 10-year average and prices fell 3%. Royal LePage expects Vancouver prices to increase 2% in 2013, but then their commissions are based on a percentage of selling prices so they may be biased.

MMC-2013-06-Trade-Table-CAD

With both imports and exports declining, a lower trade deficit in May is a hollow victory at best. Weak global demand for our exports, particularly Europe, is mostly to blame. A stronger U.S. economy could help reduce Canada’s trade deficit.

The Canadian economy continues to grow moderately. The effects of a slowing housing sector should be offset by increased exports to a recovering U.S. consumer. Canada is also benefiting from a recovering auto industry.

What did you think of June’s market 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 fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.