October in Review: The Sky isn’t Falling, but it is Getting Darker.


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Management Portfolio

The NWM Global Bond Fund was up 1.7% for the month. The strong returns were mainly driven by currency as the USD appreciated versus CAD. In local currency terms, Pimco was relatively flat for the month while the global bond market in aggregate was considerably more stable than global equity markets. Templeton returned 2.3% as they were able to further add value due to a recovery in Argentina as well as select exposure to Brazil and Ghana.

The Mortgage Pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.4% and +0.5% respectively last month. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.2% for the NWM Primary Mortgage Fund and 5.6% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund had 11.2% cash at month end, while the NWM Balanced Mortgage Fund had 10.4%.

The NWM Bond Fund returned -0.2% in October and is +1.5% year-to-date, compared to the FTSE TMX Canada Universe Bond Index, which was -0.7% for the month and -1.1% year-to-dates. Canadian interest rates continued higher into October, and the longer duration Sun Life Private Fixed Income Plus Fund, at -0.9%, was the main negative contributor in the month. The other component strategies, and the NWM Bond Fund overall, continues to have very low duration and should outperform in a rising interest rate environment. East Coast Investment Grade II Fund was +0.2% in October, and has been the fund’s top performer this year at +5.1% year-to-date.

NWM High Yield Bond Fund returned +0.1% in October and is +3.6% year-to-date. Oaktree Global High Yield was -1.5% in October, closely matching the ICE BofAML US High Yield Index’s down month of -1.6%, but in general, the component funds stood their performance ground in what was a volatile month for high yield. Picton Mahoney Income Opportunities Fund was the largest positive monthly contributor at +0.7%. Currency had a large effect on the fund in October given the fund’s 40% USD exposure benefited from the 1.9% decline in the Canadian dollar.

Returns for the NWM Core Portfolio Fund were down 1.5% in the month of October.  The NWM Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.

The NWM Preferred Share Fund returned -3.0% for the month while the BMO Laddered Preferred Share Index ETF returned -2.7%.  The preferred share market held in for the first few days of the month before falling in symphony with the rest of the equity markets. Unlike the preferred share sell off during 2015, which was led by retail sellers, the weakness during the past month seemed to be led by ETF selling. More liquid and higher beta preferred shares bore the brunt of the sell-off. This type of selling led to dislocations to fundamentals as narrow rate reset preferred shares sold off despite the five year Government of Canada bonds rising nine basis points.  As a result, we purchased lower and mid-rate resets from issuers such as Enbridge and Brookfield at the end of the month. During the month both Scotia Bank and Royal Bank issued new shares with Royal coming in with a 238 basis point spread. We purchased the issue as safe preferred shares, however we are cognizant of the decline in rate resets over the past three years and will continuously monitor the spreads both on an absolute basis and relative to corporate bonds.

Canadian Equities were very weak in October with the S&P/TSX -6.3%. The NWM Canadian Equity Income Fund was -7.3%.  Health Care and Information Technology were positive contributing sectors for the fund as the high valuation marijuana and tech sectors were hit hard in the correction (the NWM Canadian Equity Income Fund had no exposure to either of these sectors). This was offset by poor months in industrials and materials, where we did not have an allocation in gold stocks and had an overweight position in lumber. We added a position in Methanex in October. The methanol market is tight and pricing has surprised to the upside. Iran sanctions could cause some global prices to move higher as India is very dependent on Iranian methanol. Top contributors to performance last month were Aritzia, Suncor, and CNR. Top detractors were Intefor, Heroux-Devtek, and Canadian Natural Resources.

The NWM Canadian Tactical High Income Fund returned -3.5% in the month, which was relatively better than the S&P/TSX’s -6.3% return.  Last quarter’s top performing sector, Health Care, was down ~18% in the month (Cannabis stocks were down ~20%). The NWM Canadian Tactical High Income Fund was underweight the three bottom performing sectors relative to the market which contributed to relative performance.  Option volatility spiked higher, with the Canadian VIX increasing 43%; the NWM Canadian Tactical High Income Fund took advantage of the high implied volatility by lengthening option maturities with good risk reward payoffs.  SNC Lavalin, Manulife & Waste Connections were new names added this month; we also bought more IGM Financial, sold our entire position in Cott, and trimmed Guardian Capital Group.

The NWM Global Equity Fund returned -6.4% vs -5.9% for the MSCI ACWI (all in CDN$).  The NWM Global Equity Fund underperformed the benchmark due to currency (less USD$ exposure), country selection (underweight U.S. & overweight U.K & Japan) and sector selection (underweight utilities and overweight materials & Industrials).   Style and market-cap also had an impact as the NWM Global Equity Fund was tilted more towards growth and small-cap vs the benchmark.  Performance of our managers in descending order was ValueInvest -0.90% (benefited from large weight in consumer staples), BMO Asian Growth & Income -5.72%, C Worldwide -6.90%, Edgepoint -7.53%, NWM EAFE Quant -7.61% (Growth, market cap, stock selection factors detracted from performance) and Lazard -11.16% (weak stock selection within U.S., U.K. & Japan).

The NWM U.S. Equity Income Fund was down -7.6% in October, while the S&P500 was down -6.8%.  In terms of attribution, our positions in Procter & Gamble, Nextera Energy, and not owning Amazon helped, while owning AIG, Newell Brands, and Valero hurt.  No new names were added and nothing was sold, however we added to existing positions on weakness: packaging company Westrock as well as housing-related names Home Depot, Weyerhaeuser, and Sherwin-Williams.  We trimmed our exposure to Union Pacific, Citigroup, and L3 Technologies.

The NWM U.S. Tactical High Income Fund’s performance was -3.5% vs -6.8% for the S&P 500.  The NWM U.S. Tactical High Income Fund’s outperformance was mostly due to being underweight Healthcare & Info Tech and relative stock selection within consumer discretionary (retail sub-segment).   Option volatility increased 76% during the month which provided opportunities to lock-in high implied vols with longer maturities. Two new names were added to the NWM U.S. Tactical High Income Fund this month, Home Depot & Waste Management.  We made a significant change in the composition of the float to reduce credit risk exposure as we have sold more PIMCO Monthly Income Fund and have purchased money market funds and U.S. Treasures (1 year treasuries are yielding ~2.75%).

The NWM Real Estate Fund was +0.8% for the month of October vs. the iShares (XRE) -1.6%. The publicly traded REITs were weaker for the month but outperformed the broader TSX market which was -6.3%. We have an overweight in the Residential REIT sector which continues to exhibit strong performance compared to the broader REIT universe. The NWM Real Estate Fund is currently weighted 25% publicly traded REITs and 75% LPs which exhibit lower volatility (quarterly appraisals and NAV updates). In October we added the Invesco Core Europe LP (8% weight). With the North American real estate cycle continuing to mature, we think that the timing is right to diversify the fund globally. At the end of the September, we received a capital call for the Invesco Core Europe Fund (8% weight pro forma). We sold Artis REIT and H&R REIT to help fund the purchase.

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of October 31st, September performance for SPIRE Real Estate Limited Partnership was +0.1%, SPIRE U.S. Limited Partnership +1.2% (in US$’s), and SPIRE Value Add Limited Partnership +0.9%.

The NWM Alternative Strategies Fund returned 0.6% in October (these are estimates and can’t be confirmed until later in the month).  Currency contributed 1.9% to returns as the Canadian dollar weakened despite a new trade deal between Canada, the US, and Mexico. In local currency terms, Winton returned -2.3%, Millennium -1.1%, Apollo Offshore Credit Strategies Fund Ltd -0.1%, Verition International Multi-Strategy Fund Ltd -0.5%, RPIA Debt Opportunities +0.1%, and Polar Multi-Strategy Fund +0.1% for the month. Despite reducing equity exposure at the beginning of the year, Winton was not been able to escape the equity downturn in October. Long positions in the S&P500 detracted from returns along with long base metal and natural gas. These detractors were not offset enough by positive returns from relative value exposure in fixed income and short currency exposures in the Euro, Swedish Krona, and Swiss Franc.

The NWM Precious Metals Fund returned -1.0% for the month, underperforming underlying gold stocks in the S&P/TSX Composite index which returned +2.2% while gold bullion rose 4.0% in Canadian dollar terms. The negative returns for the NWM Precious Metals Fund were driven by the fall of Guyana Goldfields which returned -37.9% for the month and is a large holding in the Sentry precious metals fund. The sell-off was caused by uncertainty on the grade profile of the company’s resource model and exacerbated by a rebalance out by one of its larger holders. Sentry is constructive on the name as they believe that that the stock price does not reflect the asset value of Guyana and the large selling in the stock was mainly due to a mandate change.

October in Review

In hunting for asset classes in the red last month, one didn’t have to look very hard.

It was a red October, for both equities and fixed income.  For stocks, all global exchanges ended the month lower, with the S&P 500 down 6.8% and the S&P/TSX -6.3%.  A weaker Canadian dollar (also in the red for the month, declining nearly 2%) meant Canadian investors in the S&P 500 lost “only” 5.3%.

Europe (STOXX Europe 600) was down 5.5%, while China (Shanghai Composite) lost 7.7% and Japan (Nikkei 225) -9.2%, all in local currency terms.  According to S&P Dow Jones Indices, stocks around the world lost more than $5 Trillion in market Cap last month.

As bad as these results were, a nice rally in the last two trading sessions of the month helped limit the decline.  Before the bounce back, U.S. equities were headed for losses of nearly 10%, very close to correction territory.  It was nearly all trick for investors last month, with a little treat to finish off the month.

Historically, when equities sell off this hard, bonds help soften the blow as yields fall and bond prices rise.  Such has been the positive correlation between stock prices and bond yields over the past two decades, but not last month.  According to Ryan Labs, despite the downdraft in stocks, 30 year Treasury bond prices fell over 5% in October, a cruel trick indeed.  Pictet Asset Management reports a traditional 60% Equity/40% Bond portfolio would have declined 3.5% in October and -1.5% year-to-date.

Only in 1990, 2001, and 2002 has a 60/40 portfolio gone on to finish the year in the red.  For investors, there was truly nowhere to hide.  Well, unless of course you were a client of Nicola Wealth Management, but more about that later.

October could be the start of something scarier, like a bear market.

Was October a normal correction, like we experienced in February, or the start of something scarier, like a bear market?  Should investors buy the dip, or sell the rip (rally)?  In order to help answer this question, and a few more, we are going to dive into last month’s market performance in a little more detail before looking at some of the issues concerning investors last month.

Spoiler alert, we think the environment is still bullish, but risks have continued to build.

 

While the correction in January and February was even larger from a price decline perspective than last month’s (perhaps because it spanned two separate months and the S&P 500 had actually retraced over half of its decline by the end of February), October’s selloff felt different, and not in a good way.

Traders have likely become accustomed to a lack of volatility in the QE induced post financial crisis environment such that a good dose of volatility feels unsettling.  And who can blame them (us).  Until rallying the last two trading sessions of the month, October returns were headed for their worst monthly loss since February 2009, erasing gains for the entire year and falling 15 of 18 trading sessions.

Two of those 15 losing days were amongst the five worst daily drawdowns for the S&P 500 since 2015.  According to the market, the message appeared pretty dire.  Bloomberg’s Cameron Crise calculates the market began pricing in an eight-point decline in the ISM Purchasing Managers Index while J.P. Morgan postulated that 2018 could mark the first time in 40 years where most asset classes post negative returns without the global economy being in a recession.

Looking more closely at the market itself, the mystery deepens.  Growth and momentum stocks sold off hard, as did the Russell 2000 (small capitalization stocks) and the NASDAQ (technology).  Alternatively, utilities and consumer staples faired relatively well.  Investors were selling their winners (companies that have exhibited strong price and earnings momentum) and buying defensive names more immune to a slowing economy.

These market actions become more visible when companies began reporting third quarter earnings.  For only the third time in five years, the S&P 500 declined during earning season, with even companies that reported positive earnings surprises coming under pressure.  According to FactSet, with nearly half of S&P 500 companies having reported, companies with better-than-expected earnings saw their stocks fall an average 1.5% during the two trading days before and after reporting, the largest decline since 2011.  Sanford Bernstein reported an even more severe decline of nearly 9% for companies missing both earnings and revenue estimates.

Clearly analysts have become more bearish on corporate earnings, although not that bearish.  Earlier in the year, FactSet reported long-term estimates for S&P 500 earnings growth over the next three to five years was 14%, the fastest since 2001.

Recently, FactSet dropped the rate to 12.9%, which while lower than 14%, is still above the 15-year average of 11.4%.  For the third quarter, financial-data firm Refinitiv believes earnings are on track to rise 27.1% year over year, above 25% for the third quarter in a row.  Expected revenue growth of 8% is a bit slower than the last three quarters, but also still well above normal.

In combination with earnings moving materially higher, falling stock prices can have a dramatic impact on valuations.

For the S&P 500, forward price/earnings multiples fell back to its long-term average (since 1990) while the correction in Canadian stocks took the S&P/TSX forward P/E multiple a couple points below its long-term average (since 1990).

Of course, if earnings growth is slowing because the economy is about to go into recession, then future earnings will come under pressure and the market will not look so cheap.  But is this the case?

Earnings growth may have peaked, but does this signal a looming recession? 

Eventually, yes, but the numbers just don’t show this as being a big risk in the near term.  U.S. GDP probably peaked in the second quarter with real growth of 4.2% and is forecast to moderate back down to around 2.5% early next year, but with consumer confidence remaining steady at pre-financial crisis levels, the real economy appears to be shrugging off concerns the capital markets seems fixated on.

Franklin D. Roosevelt once famously said, “The only thing we have to fear is fear itself,” and it’s true – lower stock and bond prices can, in themselves, negatively impact the real economy.

According to Goldman Sachs, the negative wealth effect impact of a falling stock market could shave 0.25% off of GDP in the first half of 2019 and result in tighter financial conditions as households and companies spend less, but it is unlikely enough to cause the economy to contract.

Man up stock market!  It’s just not that bad out there.

This is especially so, given how strong the job market is.  Last month, the U.S. economy created 250,000 new jobs, holding the unemployment rate at 3.7%, the lowest in 49 years.  Based on current data, there are over one million more job openings than unemployed workers in the U.S. and according to the University of Chicago’s Steven Davis it takes, on average, a record 32.3 working days for employers to fill a vacant position. How much longer can the job market perform at these levels?  Federal Reserve Chairman Jerome Powell believes “indefinitely.”

The Federal Reserve believes the Phillips Curve has flattened such that a continued fall in the unemployment rate should only result in a relatively small increase in inflation.  Powell thinks the unemployment rate can average around 3.5% with inflation continuing to be anchored near 2%.  It’s an interesting hypothesis, especially considering the Fed is also on record as pegging the natural rate of unemployment (the long-term rate which is neither inflationary nor deflationary) closer to 4.5%.

 

Powell is likely widely optimistic.  Eventually the U.S. will run out of workers.  While the labour force expanded by about 844,000 workers over the past year (as of September), non-farm payrolls increased by 2.5 million.

The key in the short term might lie with the labour participation rate and its ability to normalize.  The unemployment rate only measures people actively looking for work while the participation rate measures the percentage of the entire population that is actually employed.  At 62.9% in October versus around 66% before the Financial Crisis, the participation rate is indicating there still maybe untapped slack in the labour force which can be lured back to work without driving wages and inflation dangerously higher.

Some of the decline in the participation rate is due to an aging demographic, but given the participation rate of 25 to 54 year old workers is still below pre-financial crisis levels, demographics don’t explain the entire shortfall.  These idled workers don’t have the job skills required to participate in the workforce, are disabled and unable to work, or would rather play video games and live in their parents’ basement.  The latter would be classified as slack in the labour force.  Or just slackers for short.

 

Another area of potential slack for the U.S. economy might be business investment spending.  According to a recent Bank of America Merrill Lynch Fund Manager survey, most institutional investors believe the economy is late in the cycle, meaning a recession is getting closer and closer.

If companies are able to increase their productivity by investing in automation and other cost saving initiatives, the economy will be able to continue growing without incurring inflation, thus extending the cycle.  So far, the jury is still out on determining whether business spending will provide the economy a second wind.  Companies indicate they are planning to spend more, but actual spending has declined after the initial bump provided by tax-law changes earlier in the year.  Even much-needed oil and gas structure and equipment spending appears to be stalling.

A strong job market with a slowing economy provides an interesting challenge for the markets, and the Federal Reserve. 

The low unemployment rates and recent wage gains point to an economy posed to overheat.  At the same time, however, inflationary expectations appear stable and economic growth looks to have peaked.  As mentioned earlier, when stocks sell off, bond prices have historically moved higher (yields lower) as investors seek the safety of U.S. treasuries.  But when higher interest rates are one of the factors causing investors to sell, what should investors do?

In February when stocks started to sell off, bond yields continued moving higher, eventually topping out at 2.95% before finally moving lower and providing some support to the stock market.  But it took a month!  With October’s correction, it took only a couple of days for bonds to react, and while yields stopped moving higher, they have also remained stubbornly high.  Inflation and higher interest rates have shifted from being seen as a good thing for the market to being seen as a threat.

Against a backdrop of stronger (but slowing) economic growth, the Federal Reserve believes it has the opportunity to remove the unprecedented monetary stimulus it deployed during the Financial Crisis and continue raising overnight interest rates in order to normalize monetary policy.

Chairman Powell and the Fed appear to be on a mission to raise rates once more in 2018, and three more times in 2019, despite conceding they aren’t precisely sure what normal, or neutral, levels are.  This admission was a little too much for the market to handle last month. Once 10-year treasury yields began moving higher and approached the psychologically important 3.25% level (they reached 3.23% before turning lower), equity investors had seen enough and started to sell.

According to a recent Barron’s “Big Money Poll” of institutional investors, rising interest rates, or policy missteps, is considered the biggest threat to the market today.  Perhaps the bigger question is whether the Fed really cares.  President Trump believes the Fed “has gone crazy” and is “getting a little too cute,” but Powell and friends likely view the market through a different lens than a President who has used the stock market as a measuring stick of his success.

The Fed takes a longer-term view and is less concerned with a little volatility. Like President Trump, investors have gotten used to an environment where fundamentals didn’t matter when the cost of capital was effectively zero.

Don’t worry, the Fed’s got your back.  The Greenspan Put (so called because when the market came under pressure, the market believed the Fed would cut interest rates, thus providing support for stocks, like a put option for investors) became the Bernanke Put, which became the Yellen Put.  Now perhaps there will be no Powell Put, which is too bad because it sounds kind of catchy.  Trump would like to initiate the Trump Put, standing by with fiscal stimulus when the market needs it, but congress is unlikely to cooperate.  So now the market is left to rely on fundamentals again, and that means more volatility.

 

Looking beyond the traders’ and President Trump’s myopic view of the market, historically higher interest rates have actually been good for equity returns.  Yields tend to move higher when the economy is doing well, as do corporate profits.  According to BMO’s Brian Belski, rolling 1-year performance for the S&P 500 has historically peaked when the 10-year Treasury yields rises between 50 to 100 basis points year over year, averaging gains of 17.9% since 1990.

Over the past year, 10 year Treasury yields are up 88 basis points, right in the sweet spot.  Also, while the Fed is raising rates, with real overnight still near zero (Nominal Fed Funds rate is 2.0% to 2.25% while inflation is around 2%) monetary policy is still considered stimulative.  As macro institutional research firm Strategas recently pointed out, it’s unheard of to have a recession when Real Fed Funds rates are near zero.

Eventually higher rates will increase and reach a point where the economy rolls over and the business cycle ends.  According to Credit Suisse, the inflection point for the market has historically been when 10-year Treasury yields hit 5%, but many feel a decade of near-zero interest rates means the threshold this cycle will be much lower, possibly as low as 3.5%.  While this may mean the end of the current bull market is in sight, investors need to keep in mind the end of a bull market can be one of the most profitable for investors.

According to Bank Credit Analyst, in the last quintile and decile of a bull market, as measured in number of days, the S&P 500 has provided above average returns, second only to the first quintile and decile.

With rising interest rates, it’s finally time to start normalizing monetary policy. 

While rising interest rates and a slowing economy may be unsettling, it doesn’t necessarily signal a recession or an end to the bull market.  Interest rates are rising because the economy is strong and it’s finally time to start normalizing monetary policy.

Corporate earnings growth may be slowing, but it’s still growing.  Also, valuations have come down, thanks to record earnings and a nice correction.  Geopolitical risks, like a trade war, or worse, are elevated, but it’s hard to determine what this means for markets.  So far, it’s not been a big driver.

According to Morgan Stanley, buying the S&P 500 after a down week has been a profitable strategy every year since 2005 and has been responsible for most of the post-Financial Crisis bull market returns, until this year.  Buying the dip in 2018 has been a losing strategy for the first time in 13 years.  And yet in 65 years of surveying the S&P 500, Morgan Stanley also finds sharp initial drops, like the one we experienced last month, typically turn out to be run-of-the mill corrections (drops of 10-20%) and markets, on average, recover within six months and rally within a year.

The thinking is that markets don’t become smarter overnight and the information signaling an end to the economic cycle and beginning of a bear market tends to trickle in over time.  More frequent corrections might be part of the “trickling” process, but not the defining signal.

 

The bull market still has room to run, but it’s going to be tough for investors.

So do you buy the dip, or sell the rip?  Well, yes, to both.  We think the bull market still has room to run, but it’s going to get tougher for investors as volatility increases and the current economic cycle gets closer to an end.  If investors are under weight and waiting for an entry point, by all means look to selectively buy stocks, especially quality companies that have exhibited the ability to grow their dividends.  We do not, however, believe investors should be looking to increase risk in their portfolio.

Now is the time to start becoming more defensive, so use market rallies as an opportunity to rebalance, not market time.  Diversification is always our preferred approach, but will become even more important going forward.  Illiquid, non-mark to market assets (not traded on a public exchange providing up to the minute pricing and values) like real estate, private equity, private debt, and mortgages, can help reduce short-term price volatility like we saw last month.  We don’t think the sky is falling, but it is getting a darker.

 

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 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. Please speak to your NWM advisor for advice based on your unique circumstances. NWM 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. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.