By Rob Edel
Highlights This Month
- Why are stocks hitting all-time highs?
- Markets came under pressure in early October as global economic growth appeared to be stalling.
- Pessimism over economic growth carried through to concerns over corporate earnings.
- The biggest positive catalyst for stocks last month, has been the prospect of break-through in the US/China trade war.
- Flashing a more optimistic signal last month was the yield curve.
Returns for the Nicola Core Portfolio Fund were 0.5% in the month of October. 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 0.2% in October and is +5.3% year-to-date. The majority of returns once again came from duration exposure as credit spreads were flat to slightly tighter across the board. Instead of a parallel movement in the yield curve with all terms moving up or down in tandem, short dated bond prices edged higher (yields lower) while long-term bond prices sold off -0.7% (yields up) as the yield curve steepened.
This phenomenon was reflected in returns for your underlying investments, with East Coast and Marret returning 1.0% and 0.5% respectively while Sunlife Private Fixed Income plus, which has longer duration, returned -0.4%. The strong returns for the year have been driven by a bull flattening of the yield curve (declining longer term bond yields). We continue to remain constructive in the corporate credit market but remain concerned on long duration assets.
The Nicola High Yield Bond Fund returned -0.1% in October, and is +4.7% year-to-date. Spreads widened during the month but yields remained roughly the same as interest rates declined. CCC rated securities, particularly energy, telecom, and healthcare names continue to be weak. The spread between CCC and BB’s is now close to the highest it has been in a decade. We continue to remain relatively conservative with a focus on high quality, high yield while cautious on private equity sponsored companies. October also saw significant weakness in the loan market despite no material defaults. Approximately half the loan market is represented through the CLO market (collateralized loan obligation) where investors frequently are not long term holders, so the weakness may be short lived.
The Nicola Global Bond Fund was up 0.5% for the month. All managers had positive returns for the month with both Templeton and Pimco leading the way +0.6%. Globally, Brazil, Mexico, and Argentina all contributed to returns. Argentine bonds moved from lows around $0.35 to $0.4 which help offset continued weakness in the currency.
An overweight to higher quality assets also contributed to returns as investment grade bonds saw spread tightening while high yields saw spreads widen. Additionally, select negative exposure to interest rates in Europe helped returns as interest rates generally rose in the region.
The Mortgage Pools continued to deliver consistent returns, with the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund returning +0.3% and +0.4% respectively last month. Current yields, which are what the Nicola Primary Mortgage Fund and the Nicola Balanced Mortgage Fund would return if all mortgages presently in the two Nicola mortgage funds were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.0% for the Nicola Primary Mortgage Fund and 5.4% for the Nicola Balanced Mortgage Fund. The Nicola Primary Mortgage Fund had 19.6% cash at month end, while the Nicola Balanced Mortgage Fund had 17.8%.
The Nicola Preferred Share Fund returned +0.2% for the month, matching the BMO Laddered Preferred Share Index ETF. Volatility in preferred shares was relatively muted for the month even as 5 year Government of Canada bond yields continued to have large swings up and down. 5 year bond yields closed the month at 1.42% while intra-month we saw yields move to a low of 1.25% and a high of 1.64%. Part of the rate volatility was driven by the Bank of Canada, despite keeping interest rates unchanged, a dovish tone caused financial markets to re-price expectations.
The S&P/TSX was down -0.9% while the Nicola Canadian Equity Income Fund was -0.7%. The Materials sector was the largest positive contributor to the Index for October followed by Financials. Energy was the largest negative contributor. The outperformance of the fund was mainly due to solid performance in individual names in the Consumer Discretionary and the Communications sectors.
On an individual stock basis, the top positive contributors to the performance of the Nicola Canadian Equity Income Fund were Aritzia, Park Lawn, and Interfor. Largest detractors to performance were Pinnacle Renewable, Maple Leaf Foods, and Spin Master. We added two new positions in the month: Telus and Minto Apartment REIT.
The Nicola Canadian Tactical High Income Fund returned -0.3% vs the S&P/TSX’s -0.9%. The Nicola Canadian Tactical High Income Fund benefited from exposure in the Materials and Industrials sectors but this was offset by weakness in Consumer Discretionary, Consumer Staples and Energy sectors. Though option volatility decreased 10% during the month, the Nicola Canadian Tactical High Income Fund was able to find opportunities to earn double-digit Put option premiums with high single-digit downside protection on select names.
The Nicola Canadian Tactical High Income Fund has an equity-equivalent exposure of 65.9% (62% prior) and remains defensively positioned with companies that generate high free-cash-flow and generally have lower leverage relative to the market. Shaw Communications is a new name to the portfolio.
The Nicola U.S. Equity Income Fund returned +1.3% (USD), while the S&P500 returned +2.2%. It was a risk-on environment where defensive sectors such as the S&P500 Utilities and Consumer Staples sectors lagged the market, returning -0.8% and -0.2% respectively, while the IT, Financials and Industrials sectors returned +3.9%, +2.4% and +1.1%. In terms of relative attribution, our defensive position in Consumer Staples was a drag on performance. Positive performance from NVidia, Valero Energy, and UnitedHealth were outweighed by our positions in Boeing, Hormel Foods, and Progressive. No new names were added, and we exited Newell Brands.
The Nicola U.S. Tactical High Income Fund returned +0.9% vs +2.2% for S&P 500. The Nicola U.S. Tactical High Income Fund’s relative underperformance was due to being underweight Healthcare, Communication Services, Financials and Info Tech as well as adverse stock selection within Consumer Discretionary (L Brands, Delphi & Big Lots). Overall, the Nicola U.S. Tactical High Income Fund posted a positive return, helped by some of our cyclical names (Valero & Oshkosh; both were up double-digits). Option volatility decreased 18.6% during the month with the largest amount of volatility occurring at the beginning of the month.
The Nicola U.S. Tactical High Income Fund has been very selective in deploying capital. At one point during the month, the Nicola U.S. Tactical High Income Fund’s long-only positions were 70% covered by call options. The combination of the rally in stocks and the option-overwriting decreased the delta-adjusted equity from 41.3% to 40.2%. The portfolio remains defensively positioned with a lower valuation multiple, and higher free-cash-flow with similar leverage relative to the S&P 500. Four new names added to the portfolio: Starbucks (previously owned), Middleby Corp. (Food equipment manufacturer), Boeing and Delta Airlines (best in-class U.S. airline).
The Nicola Global Equity Fund returned +1.6% vs +2.2% for the IShares MSCI ACWI (all in CDN$). Country performance was mixed with positive contribution coming from our relative overweight in Japan, France & UK, but was partially offset by the relative overweight in Canada and Switzerland. The Nicola Global Equity Fund was underweight the top performing sectors last month namely Info Technology & Healthcare.
Overall, our growth and small-cap managers outperformed our large-cap defensive managers. Performance of our managers in descending order was Nicola EAFE Quant +3.6%, BMO Asian Growth & Income +2.8%, Pier 21 C Worldwide +2.5%, Lazard +2.4%, Edgepoint Global +0.5%, Pier 21 Global Value -0.3%
The Nicola Global Real Estate Fund was flat (+0.02% to be exact) in October vs. the iShares (XRE) -0.4%. Publicly traded REITs exhibit a strong inverse correlation with long-term rates and the slight back up in bond yields in October was a headwind for the sector. Overall with the vast majority of long-term global government bond yields trading at or near 12-month lows, the interest rate environment is still positive for real estate. Current valuation levels are fair but further multiple expansion may be difficult to achieve. We think that the best opportunity is to be in the multi-family and industrial sectors where the multi-year outlook appears strong for rental growth. We added Canadian Apartment REIT and Northview Apartment REIT to the portfolio in October.
We report our internal hard asset real estate Limited Partnerships in this report with a one month lag. As of October 31st, September 30th performance for the Nicola Canadian Real Estate LP was 1.2%, Nicola U.S. Real Estate LP +1.0%, and Nicola Value Add LP +1.6%.
The Nicola Alternative Strategies Fund returned -0.2% in October (these are estimates and can’t be confirmed until later in the month). Currency detracted -0.4% to returns as the Canadian dollar strengthened through the month. In local currency terms, Winton returned -2.1%, Millennium 1.0%, Bridgewater Pure Alpha Major Markets -0.7%, Verition International Multi-Strategy Fund Ltd 1.5%, Renaissance Institutional Diversified Global Equities Fund 0.8%, RPIA Debt Opportunities 0.9%, and Polar Multi-Strategy Fund -0.4% for the month. Verition helped offset some of the losses from Winton which saw continued losses from trend reversals. Losses came from positioning in fixed income and currencies as German government bonds and Eurobond futures detracted from returns as well as a short position in the Euro.
The Nicola Precious Metals Fund returned 4.4% for the month while underlying gold stocks in the S&P/TSX Composite index returned +5.0% and gold bullion was up 2.1% in Canadian dollar terms. The parabolic rise in gold seems to have stabilized around $1,500. The precious metals market historically has been very volatile. The macro environment may be potentially improving in terms of both geopolitical risk and economic data, which is negative for gold prices. Both Brexit and US / China trade issues are moving in the right direction and global manufacturing may be forming a trough. A move higher in interest rates may cause further volatility in the gold market as real interest rates decline. The RBC Global Precious Metals Fund marginally outperformed the overall market supported by a strong month for Wesdome Gold Mines which returned 34.8% for the month.
October in Review
Equity markets continued to move higher last month, with the S&P 500 hitting a new all-time high in late October. Canadian stocks were unable to rise above September’s high water mark, mainly due to weak oil and gas stock returns and the falling cannabis sector, but the S&P/TSX is up over 18% year to date.
Year to date, actually everything is having a good year, with stocks, bonds, gold, and oil all rallying. This is not normal. Based on data going back as far as 1984, stocks, oil and gold have never risen more than 10% and bond yields fallen 1% (yields down so bond price up) during the first three quarters of the year.
The last time just stocks and 10 year Treasury yields both had moves of this magnitude was in 1995. It’s been a can’t miss market for investors, yet while the S&P 500 is setting records, traders appear very timid. Net flows into bond and money market funds have increased year to date but flows into equity funds have been negative. According to Goldman Sachs, flows into bonds and cash relative to stocks have been at their highest level since 2012.
In fairness, there are certainly valid reasons to be timid. Global economic policy uncertainty hit a record high in August with Brexit and the U.S. China Trade war dominating headlines. If that wasn’t enough, Turkish military incursions into Syria, attacks on Saudi Arabian oil fields, social unrest in Hong Kong, political turmoil roiling Argentina markets and impeachment hearings in the US, and it’s a wonder why investors aren’t more cautious.
Why are stocks hitting all-time highs?
It certainly helps explain why gold and oil are up, and maybe even why bond yields are down, but why are stocks hitting all-time highs? Progress on the US/China trade war and central bank easing drove valuations higher last month. Global growth has slowed this year, but traders hope this trend will reverse if the trade war cools and the Federal Reserve continues with their loose monetary policy. Rather than forecasting a full blown recession, markets have begun to act like the economy has experienced a mere mid-cycle correction. In this month’s comment we attempt to determine if they are right.
Markets came under pressure in early October as global economic growth appeared to be stalling.
Manufacturing indices in Europe and Japan had turned negative earlier in the year and US manufacturing looked to be headed in the same direction. Expectations of a big stimulus package from China faded as China’s third quarter GDP growth fell to 6%, the bottom of Beijing’s targeted range of 6.0% to 6.5% and lowest in nearly 30 years. An alarming decline in World trade and the mounting trade war between the US and China fueled concerns the global economy was headed for a recession.
While the trade war hurt global trade, it’s not the only factor impacting global growth.
In retrospect this was probably an over-reaction. While the trade war has hurt global trade, it’s not the only factor impacting global growth. China has seen exports growth decline, particularly to the US, but the total exports are still growing, particularly to emerging market countries.
In order to reign in credit growth and rebalance its economy, China has intentionally let economic growth slow. As for the US, business investment has turned negative as the uncertainty of the trade war has kept corporate spending plans on hold, but consumer spending, which comprises close to 70% of the US economy, continues to be strong. And why shouldn’t it be, jobs and wages are on the rise.
In October, US companies added to payrolls for a record 109th straight month, and while job growth has slowed from last year, with the unemployment rate at a near 50 year lows, some slowing should be expected. Lower industrial production growth can also be explained by strikes at GM and a temporary halt of production at Boeing of the 737 Max. These declines should be transitory.
Pessimism over economic growth carried through to concerns over corporate earnings.
While third quarter earnings are expected to be down 2.7% year over year, in the red for the third consecutive quarter, this was better than most forecasters predicted and earnings growth is expected back into the black again next year. Stronger earnings growth is particularly good for value stocks, which have recently started to outperform, and also a positive sign for the US economy. Investors tend to stick to growth stocks when growth is scarce and the economy is slowing. A shift to value could indicate investors are seeing growth broaden, especially to more cyclical sectors.
While no firm deal has been stuck, some kind of agreement between and US and China looks to be in the works. In what’s being framed as the first phase, the US will agree to lower tariffs, or at least refrain from increasing them, in exchange for agricultural purchases President Trump is claiming will total $40 to 50 billion a year (though nothing has been written on paper and China has yet to confirm Trump’s numbers).
Apparently China has also made vague assurances on intellectual property protection and greater access for foreign financial services, but the real heavy lifting would happen in a phase two agreement tackling thornier issues like Chinese technology theft against US companies and State subsidies to Chinese companies. While President Trump enthusiastically described the deal as “tremendous”, based on what has been discussed in the press, the substance of the deal looks more modest and is really more of a truce.
China’s ability to even buy up to $50 billion in agricultural goods is questionable. According to the Commerce Department, US agricultural exports to China peaked at approximately $29 billion in 2013 and declined to $24 billion in 2017, before the start of the trade war.
Sales have slumped to $9.2 billion over the past 12 months and in order for China to quickly increase purchases anywhere near the $50 billion level, Beijing would need to direct state-owned enterprises to buy American goods, an example of managed trade and exactly the kind of practice the US would be targeting in any phase two agreement.
There are other trade barriers both countries are using in addition to tariffs that are likely not going away.
This phase one agreement is just window dressing. There are other trade barriers both countries are using in addition to tariffs that are likely not going away. According to BNP Paribas, if all non-tariff restrictions are included, the effective tariff rate on China currently stands at 28%. When China joined the WTO in 2001 it was only 4%. A recent Washington Post article detailed a plan by the US State Department to apply the concept of “reciprocity” when dealing with China. If US Diplomats in China have to receive permission before they can visit various institutions in China, Chinese Diplomats in the US will be required to do the same.
For its part, China is finding it harder and harder to buy American goods. Younger Chinese prefer domestic brands, believing the quality is as good as, or better than American brands, a big shift from their parents who were drawn to foreign made goods. Given the choice, more Chinese consumers are showing their nationalistic loyalty to “Make China Great Again” and buying Chinese brands. We may have a truce, but this war is only just starting.
Federal Reserve lowered overnight rates by 0.25%.
The other event pleasing the market last month was actions by the Federal Reserve, who as expected lowered overnight rates by 0.25% for the third time this year to a range of 1.50% to 1.75%. Easier monetary conditions are good for the economy, and good for the market. Too much of a good thing can be bad news, however, and three cuts has historically been the dividing line between good and bad. There have been several occasions historically when the Federal Reserve has implemented a so called insurance policy or mid-cycle adjustment of three cuts, including twice in the 1980’s and twice in the 1990’s during an era now referred to as “The Great Moderation”. In both cases the market went on to record gains. If more than three cuts are required, however, like in 2001 and 2007, it’s usually a sign there are more systematic problems in the economy and a recession and market declines soon follow. After lowering rates in October, Chairman Powell has signaled a pause, which might mean the Fed will stop at three cuts. So far so good.
Flashing a more optimistic signal last month was the yield curve.
As discussed in previous months, the spread between 10 year versus 3 month treasury has been negative since May, historically a near perfect predictor of an impending recession. With the Fed cutting rates as predicted last month, the 10 year versus 3 month treasury spread turned positive again.
Initially, it was the drop in short rates that caused yield curves to un-invert, but the yield curve went on to steepen, with 10 year yields moving higher as traders became more comfortable with the future outlook for the economy. And it wasn’t just US government bonds, most developed market government bond yields moved higher as the prospects for global growth brightened, spurred on by prospects of a trade deal. Yields remain very volatile, however, especially compared to equity volatility. If the trade deal falls apart or global growth stalls, expect yields to quickly reverse course and move lower.
Elizabeth Warren being elected US President in 2020 could increase volatility.
Another factor with the potential to increase volatility over the coming months that is not yet being fully discounted in the market is the 2020 US presidential election and the chances of Elizabeth Warren being elected President. While Warren’s polling numbers slipped a little in October, she has been closing the gap with front runner Joe Biden, whose campaign has lost momentum and is running out of money. The markets don’t care because most believe Trump will be re-elected (don’t shoot the messenger!).
In our opinion, the current impeachment hearings are just a distraction. The House and Senate will vote according to party lines (Democrats in favor of impeachment and the Senate against) and Trump will live to fight another day, or November 3, 2020 to be precise. In the meantime, Trump has the luxury of sitting back and watching the Democrats fight it out. The trick for the Democratic candidates is figuring out how to be progressive enough to win the nomination while maintaining enough flexibility to subsequently move to the center in order to win the general election. The key for Trump is the economy. If the economy is strong, an incumbent President is very hard to beat, even one as unpopular as Trump. If the economy slows, however, all bets are off. According to a recent Morgan Stanley survey, 78% of investors believe the market would fall in the first three months after a Democratic victory. Prominent Hedge Fund managers Paul Tudor Jones and Leon Cooperman believe the market could fall 25% if Warren becomes President given her progressive agenda.
So is the current rally sustainable? For the time being, yes.
Some kind of trade deal will likely be agreed to between the US and China and it should help calm markets and help capital investment get back on track, but global trade is broken and is unlikely to be the same tailwind for global growth it’s been for the last couple of decades.
Monetary policy should remain simulative, but its impact on consumer and investment spending is limited. Rates were already very low. Anyone who wanted to borrow already has. It’s good for financial assets but influence on the real economy is likely to be limited. Odds of a recession have declined at the margin but growth will likely revert back to its recent 2% trend rate leaving little wiggle room to compensate for any geopolitical mishap.
Slow growth and very low interest rates are good for stocks, and high investor cash levels could provide further upside if investors decide to join in on fun. The key remains inflation. The Fed won’t raise rates until inflation breaks materially higher. When this happens, the fun comes to an abrupt halt.
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.