Recovering Rally, Flawed Fundamentals - Nicola Wealth

Recovering Rally, Flawed Fundamentals


The NWM Portfolio

It was mainly a risk on month in March.

It was a pretty quiet month in the bond market with the NWM Bond Fund delivering coupon-like returns of 0.2%. Short rates backed up slightly with 2-year Canada’s going from 0.95% at the end of February to 1.0% at the end of March.

10-year Canada’s also backed up, with yields increasing from 1.84% to 1.87%. Nothing to get too excited about, however we would take note that 10-year yields remain under 2% – hardly indicative of strong future economic growth.

While interest rates are low and at some point will move higher, bonds still play a role in a diversified investment portfolio. If the economy weakens, real interest rates could fall even more. Bonds are also very liquid and provide a relatively high safety of capital, especially short-term bonds.

High yield bonds were a little more exciting, with the NWM High Yield Bond Fund gaining 0.5% in March, though still coupon-like returns.

Global bonds were weaker in March with the NWM Global Bond Fund down 1.1%. We still like this fund and would highlight the chart below as a clear example why.

MMC-2013-03Global imbalances raise questions

Mortgage returns were steady as usual in March. The NWM Primary and Balanced Mortgage Funds returned 0.3% and 0.6% respectively, with going-forward yields at 4.6% (up from 4.2% last month) for the Primary fund and 6.7% for the Balanced.

Preferred shares were up in March with the NWM Preferred Share Fund gaining 1.0%. We continue to look for opportunities to protect the fund from rising interest rates by increasing our exposure to floating rate issues. We also remain active in the new issue market and were able to pick up an allocation to a new TransCanada fixed floater that was attractively priced.

Canadian equities were flat in March with the S&P/TSX down 0.2% (total return, including dividends), while the NWM Strategic Income Fund increased 0.8% and the Tactical High Income Fund (CAD) was 1.9% higher.

We continue to run the Strategic Income Fund a little more aggressively and have written calls against only 12% of our equity positions. As a result, however, the projected yield for the portfolio has fallen below 4.5%.

As the market rally matures, we would look for more opportunities to write covered call option positions with the hope of increasing the portfolio’s cash yield.

Foreign equities had another positive month in March with only Carnegie and the Asia Growth and Income Fund losing ground, falling 0.5% and 1.0% respectively. The NWM Global Equity Fund gained 0.6% while the MSCI All World Index was up 1.1%.

Real estate outperformed the Canadian equity markets with the NWM Real Estate Fund up 0.4%. We continue to explore the possibility of adding more hard asset real estate to the fund and hope to allocate a position in SPIRE LP and SPIRE U.S. LP before the end of the year.

The alternative strategy funds were weaker in March. Gold bullion was flat in Canadian dollar terms (-0.2%) but gold stocks declined more, with the NWM Precious Metals Fund down 0.9%.

Gold continued to sell off in early April as investor sentiment has turned decidedly negative towards the yellow metal, reinforced recently by a sell recommendation by Goldman Sachs. The NWM Alternative Strategies Fund was down 0.9%.


By Rob Edel, CFA

March was another strong month for markets south of the border with the S&P 500 and Dow Jones Industrial Average advancing 3.8% and 3.9% respectively.

The Dow, in fact, was up 10 days in a row before recording its first loss on March 15. The last time the Dow managed to increase more than 9 days in a row was 1996.

What about our Canadian markets? Well, let’s just say we took a bit of a spring break, as the S&P/TSX was down 0.20%. And perhaps a break is in order for U.S. markets, as the prices have been running pretty hard.

The S&P 500 ended the month more than 10% above its 200 moving average, a technical threshold many strategists use to predict a market pullback. Prices are also racing higher despite earnings estimates trending lower.

The rise in the market doesn’t appear to be driven by fundamentals, as much as market sentiment.

MMC-2013-03Nine  in a row

We believe the economy is improving, but not to the degree the markets are rallying. In fact, there are conflicting signs that could be pointing to weaker growth.

A stronger economy should result in higher interest rates, which is exactly what was unfolding in mid-March with 10-year U.S. Treasuries trading well above 2%. But the move was short-lived and yields plummeted back down to 1.85% by month’s end and have continued to fall in early April.

Also, resource stocks have lagged, which is counter-intuitive if one believes the global economy is getting stronger. The Dow Jones-UBS Commodity Index is down 10% over the past 7 months and 22% over the past 2 years.

Weak commodity returns are, in fact, a major reason why Canadian markets are lagging those in the U.S. While some optimists argue weak commodity prices are due to increased supplies catching up to demand, others are concerned a slowing Chinese economy is crimping demand for copper, coal, and iron ore.

And yet investors continue to bid up stocks. Even bond fund managers are getting into the act, with end-of-year records showing 309 bond mutual funds choosing to own some stocks, the most in at least the last 10 years.

As investors begin to rotate into equities, the breadth of the market rally, which up to now has been very broad, is beginning to narrow.

While investors have been content to buy lower quality stocks over the past four years, a greater focus is now being directed to higher quality names as the rally matures.

Again, this is not consistent with an improving economic environment. But if it is not the economy or earnings that are luring investors into stocks, what is?

MMC-2013-03Row Deal

Most point to an accommodative Federal Reserve and its $85-billion per month bond-buying spree as backstopping the equity markets. While some experts are urging the Fed to stop, or at least slow down the buying, most investors believe the Fed has no intention of stopping just yet.

The Fed believes the economy will only grow between 2.3% to 2.8% and unemployment will range from 7.3% to 7.5% in 2013. Previously, the Fed has indicated unemployment would need to fall to 6.5% before they would begin to raise rates.

The street appears to have taken note. In a recent Wall Street Journal survey of 50 private economists, most believed the Fed wouldn’t start slowing the monthly purchases until November of this year and wouldn’t completely halt the purchases until May of next year.

Respondents didn’t believe short-term rates would start moving higher until June 2015 and it would be December 2019 before the Federal Reserves balance sheet returned to normalized levels.

MMC-2013-03Policy Gauges

MMC-2013-03 Slow Going

In the meantime, hope that the U.S. economy is recovering faster than other developed countries continues to encourage equity investors and strengthen the U.S. dollar. Yes, economic growth is modest at best and the recovery has been painfully slow, but compared to other countries, the U.S. is still, as bond investor Bill Gross would say, “the least dirty shirt.”

The housing market is recovering, job growth is returning (though as highlighted below, not last month) and some progress has been made on reducing the deficit, though we concede the political process remains very dysfunctional.

In addition, other positive stories – like the manufacturing renaissance and the shale oil and gas revolution – have helped encourage investors and created a rally in the U.S. dollar, but could still be in the early innings.

A reduced reliance on foreign oil would have significant implications for the U.S. trade deficit and could also alter the future of U.S. foreign policy, given the decreased need for the U.S. to source oil from the Middle East.

If oil were removed from the equation, would the U.S. even care what happens beyond its borders? It’s a question, not a conclusion.

MMC-2013-03 Going Up

MMC-2013-03The World

The U.S. isn’t the only country with a bond-buying program designed to get consumers spending. After, recently promising to do “whatever it takes” to end deflation, Bank of Japan (BOJ) governor Haruhiko Kuroda filled in the details in early April and announced plans to engineer a 2% inflation rate in two years.Specifically, the BOJ plans to buy as much as US$730-billion a year, which would effectively double Japan’s monetary base in two years. The BOJ also plans to target government bonds with maturities of up to 40 years and increase purchases of financial instruments linked to stocks and the real estate market.

The magnitude of the purchases was larger than expected and is about 60% more than the Federal Reserve’s present program. The equity market reacted favorably, as did the bond market. Predictably, the Yen plummeted, which is all part of the plan.

In fact, Barclays estimates the Yen will need to depreciate about ¥30 to the dollar in order to attain the 2% inflation target in two years.

MMC-2013-03Monetary base

In the short term, the BOJ’s aggressive strategy is positive. Japan has been stuck in a deflationary funk for years and if lower real interest rates can get Japanese consumers buying, perhaps GDP growth will follow.

It’s a slippery slope, however. If nominal interest rates increase (because inflation increases) but GDP doesn’t grow, stagnant tax revenue won’t be able to keep up with higher interest costs and Japan’s already precariously high government debt levels will soar even higher.

It is estimated that if interest rates increase by 3%, which is what some believe is needed in order to drive inflation from -1% currently to the stated 2% goal, interest costs would eat up 80% of current government revenue.

While part of Japan’s problems stem from the fact consumers and businesses have been reluctant to spend their cash hoards following a severe recession in the 1990’s that has refused to go away, Japan also has structural problems.

For example, a recent study indicates Japanese GDP would be 9% higher in 2020 if women’s employment rates were the same as men’s and the elimination of disincentives that keep women out of the workplace, like the marriage tax penalty, could help achieve this goal. This would also help Japan deal with an aging population, as would a more liberal immigration policy.

Monetary policy without structural reform is unlikely to succeed in the long term and puts Japan’s fiscal health in jeopardy.

MMC-2013-03Ignition Key

In addition to Japanese monetary policy, a stronger Chinese economy is also helping capital markets move higher.

China’s official purchasing manager’s index rose to 50.9 in March versus 50.1 in February, firmly in expansion territory. What has the market concerned, however, is property prices in China look to be moving higher again and risks taking inflation along for the ride.

New home prices rose in 66 out of 70 large and medium-sized cities in February versus the previous month, up an average 1.01% and China’s CPI rate spiked up to 3.2%. Fortunately, CPI settled back down to 2.1% in March, and even more important, food inflation, which hit 6% in February, was only 2.7% in March.

Chinese leaders are very mindful that higher housing prices and inflation in general, particularly food inflation, can lead to social unrest. If inflation looks to be on the rise, a tighter monetary policy is sure to follow.

Concerns that this will lead to a hard economic landing has Chinese equity markets on edge.

MMC-2013-03 China's inflation

Of course no market is on edge more than Europe. It seems not a month can go by without some kind of crisis emanating from the continent.

Last month it was tiny Cyprus’ turn. Cyprus is a small country. If the entire banking system of Cyprus were joined together, its assets would total only €126.4-billion – smaller than Germany’s eleventh largest bank.

Of course it is a lot smaller now and is in desperate need of a €10-billion bailout. In return, the Troika (ECB, EC and IMF) mandated depositors in Cyprus’ banks take some of the hit. While those with deposits under €100,000 were spared, clients of Laiki (the country’s second largest bank) will lose most of their money and Bank of Cyprus depositors will lose about 60% of their savings.

This is significant, because it’s the first Euro-zone bailout that has resulted in depositors bearing some of the fallout and many worry this could become the playbook for future bank bailouts.

The reality, however, is Cyprus is an offshore banking center with foreign investors accounting for much of the deposit base, particularly Russian oligarchs and money launderers. With German elections coming up this Fall, Chancellor Merkel wanted to avoid explaining to the German people why their hard earned tax money was going to bailout rich Russians.

This is particularly relevant, given a recent ECB study determined Cyprus had the highest median household wealth in the Euro zone, while Germany, shockingly, was last. Yes, the study was based on data from 2009 and 2010, but German’s feel they are being unfairly punished for their fiscal prudence, and maybe they have a point.

MMC-2013-03Geographic Divide

The European economy continues to deteriorate with evidence continuing to point to a contraction in Q1 GDP, which would be the sixth in a row. Employment in the Euro-zone fell to its lowest level in nearly seven years in Q4 2012 and as of the end of February, 19.1 million were without jobs.

The unemployment rate hit 12%, a record for the 17-year-old Euro-zone, ranging from 4.8% in Austria and 5.4% in Germany to 26.3% in Spain. Unemployment in Cyprus was a decent 14%, though we suspect it will be going much higher.

How much longer can the political system in Europe endure such social hardship before parties are elected promising less austerity and reform, and more jobs?

MMC-2013-03Ups and Downs

MMC-2013-03 Weak State

We still think the U.S. economy is recovering, though it may slow in the short term with tax increases and global issues weighing on growth.

The stock market may be getting a bit ahead of itself and a bit of a pullback could be expected – and is probably healthy.

While we are keeping our eye on inflation in China, Europe remains the biggest threat to the capital markets.

The U.S. Economy

MMC-2013-03Economic Growth-Table-US

Fourth quarter GDP was once again revised higher, to 0.4% from 0.1% previously reported. Leading indicators were also higher in February, as were durable goods orders. Manufacturing indices moved lower in March, but were still in expansion territory.

Globally, manufacturing looks to be expanding, though the momentum is modest. Overall, growth estimates have been moving higher with a recent Wall Street Journal survey predicting Q1 GDP will grow 2.2% versus the previous estimate in January of 1.7%.

While it is not robust by any means, it’s not bad given the payroll tax increases that took place at the beginning of the year and the sequester (across the board spending cuts) implemented on March 1.

The Bipartisan Policy Center, for example, estimates the sequester could shave 0.5% of GDP growth in 2013. The hope is that business spending will more than make up the difference with companies indicating they may finally be ready to increase capital spending.

MMC-2013-03Production Line

Longer-term, manufacturing is a sector we believe can begin to contribute to both economic growth and the job market.

The U.S. has been able drive unit labour costs down over the last decade such that many companies are looking to re-shore manufacturing back to the U.S. where product quality and speed to market are easier to manage.

In addition, lower energy and feed stock prices due to the shale oil and gas revolution have further enhanced the U.S.’s competitive position versus many competitors in Asia and Europe.

It won’t happen overnight, however. Trade figures still show the U.S. manufacturing trade deficit widening in 2012 to $687-billion versus $673-billion in 2011 with imports accounting for 40% of manufactured goods consumed in the U.S., a slight increase compared to last year.

In fact, while the manufacturing sector has created over 500,000 jobs since 2010, some estimate only 50,000 jobs have been created by re-shoring manufacturing back to the U.S.. Companies still look to locate production close to their big customers, and Asia is where the growth is.

Most re-shoring is slated to satisfy local demand. Also, healthcare costs and regulation were cited as barriers to expanding domestic production. It’s happening, but perhaps not as quickly as we would like.

MMC-2013-03Natural Gas prices between US and Europe diverge

MMC-2013-03 Employment-Table-US

Perhaps we were a little premature in our hopes last month that the employment situation in the U.S. had turned the corner.

Only 88,000 new jobs were created in March, far below the estimated 200,000 level needed to lower the ranks of the unemployed. The unemployment rate did fall slightly, to 7.6% versus 7.7% in February, but only because nearly 500,000 workers left the labour force.

The participation rate (the percentage of working age people who are either employed or unemployed but looking for work) has been falling for over a decade, but hit its lowest level since May 1979 last month.

Certainly, part of the reason for the decline is demographic, with fewer women deciding to work and the baby boomers beginning to retire. Many workers, however, are simply unable to find work and just give up trying. Others choose to claim they are disabled and stay on the government’s disability program until they are eligible for social security.

J.P. Morgan estimates a quarter of the decline in the participation rate since the start of the recession may be a result of workers who, despite incurring a disability that prevents them from performing their previous job, decline to look for work in a different field, fearing they will not find a position and would lose their disability benefits, which includes Medicare health insurance.

Many new applicants have limited skills and prefer the security of the disability program.

MMC-2013-03Spring Brake

MMC-2013-03 The ailing economy

On the positive side, 18,000 construction jobs were created in March and 20,000 temporary workers were added. Temporary jobs are seen as a positive indicator as they can quite often turn into permanent jobs. Combined, January and February totals were also revised 61,000 jobs higher.

Because only 7,000 government jobs were lost while 24,000 retail positions were eliminated, some believe the payroll tax cut that took effect at the end of last year was more to blame for the disappointing employment numbers in March than the sequester spending cuts that began to take effect on March 1.

However, the longer the budget cuts are kept in place, the more likely they will com/app/uploads/2013/04/MMC-2013-03Inflation-Table-US.png” width=”600″ height=”134″ />

Headline inflation increased at its fastest rate since June 2009 as gasoline surged 9.1%. The increase is expected to be temporary, however, as gasoline prices have subsequently dropped.

As detailed last month, it is not unusual for seasonal factors to cause short-term price spikes in gas prices.

MMC-2013-03 Consumer Confidence-Table-US

Consumer confidence dipped in March as higher gasoline prices and an increase in the payroll tax lightened consumer pocket books.

What should really be worrying consumers is retirement, or rather the dimming prospect of ever retiring. In a recent survey, 57% of U.S. workers had saved less than $25,000 (excluding their homes) and 28% don’t believe they will have enough money to retire.

MMC-2013-03Bleaker Outlook

Retail sales were reasonably strong in February, but this was mainly due to higher gasoline sales. Excluding gasoline, retail sales growth dropped to +0.6%.

March is looking equally uninspiring, with same store sales coming in weaker-than-expected. The increase in payroll taxes are hurting sales, but weather also played a role in March, as temperatures hit 17-year lows and snowfall reached 20-year highs.

The calendar also hurt, as Easter fell earlier this year and March sales were up against strong comparable sales from last year. Lots of excuses to choose from.

On the positive side, the recovery in the housing market and soaring stock market is making consumers feel wealthier. U.S. households are also spending less of their after tax income on debt payments.

In the fourth quarter of last year, Americans spent 10.4% of their after tax income on debt payments, the lowest level since data began being recorded in 1980. Of course, low interest rates play a significant role in this, but the degree to which U.S. consumers have deleveraged cannot be dismissed.

Perhaps the U.S. consumers and lenders have learned their lessons from the sub-prime mortgage fiasco? Sadly, this looks unlikely. While mortgage lenders have tightened up their practices, terms for car loans have been relaxed, with reports of loans of up to 97 months.

That’s just over 8 years for those of us rusty on our times tables. Have we (meaning Americans) learned nothing?

MMC-2013-03 The 97-Month Car Loan


While the job market may have disappointed in March, the housing market continues to deliver.

Sales of new and existing homes again moved higher, but it is new home building that has us believing the housing sector will continue to have a positive impact on economic growth. With inventories of homes available for sale at 20 year lows, housing starts continue to trend higher.

In addition, higher prices mean fewer home owners owe more than their houses are worth, which means less foreclosures and more worker mobility. It’s all good news on the housing front.

MMC-2013-03Spring Forward


The trade deficit narrowed slightly in February as the petroleum deficit continues to narrow. This will be the big story for the trade deficit over the coming years. As the U.S. shale oil and gas revolution plays out, the U.S. will need to import less oil.

The Canadian Economy

MMC-2013-03Economic Growth-Table-CAD

Canadian GDP grew more than expected in January, though on a year over year basis, growth is modest at best.

Manufacturing was mixed, with the February RBC Purchasing Managers Index indicating a contracting manufacturing sector for the first time since the index was created in October 2010, while the March Ivey Purchasing Managers Index pointed to stronger growth in the sector.

The American shale oil and gas boom is hurting Canadian exports such that the Bank of Canada estimates lower prices for Canadian oil reduced Canadian GDP by 0.4% in the second half of 2012.

Canada needs to build out the infrastructure that will enable us to move our oil (and gas) to market, both to U.S. refiners in the Gulf of Mexico region, and overseas.

MMC-2013-03 Branching out

MMC-2013-03 Slaking Thirst

MMC-2013-03 Employment-Table-CAD

It appears Canada’s job gains last month were too good to be true as Canada lost all the jobs gained in February, and then some, in March. Most of the jobs were full time and the unemployment rate jumped up to 7.2%.

Manufacturing, accommodation and food service, and public administration accounted for most of the losses. The moving average over the past six months is about 12,000 new jobs per month, which is probably on par for the slow GDP growth Canada is delivering. We still worry about a slowdown in residential construction, but so far, this hasn’t been an issue.


Inflation rebounded in February as gasoline prices increased 2.4% versus last year, but inflation remains modest at best.

MMC-2013-03Consumer Confidence-Table-CAD

MMC-2013-03 The Consumer-Table-CAN

Retail sales in January partially rebounded from December’s decline, but the increase was largely due to an increase auto sales.

Year over year, retail sales declined for the second month in a row; the first time this has happened since 1998 in a non-recessionary environment. Consumers in Canada may finally be starting to reign in their spending.


Home sales continued to deteriorate in February, but a moderate decline in prices and a balanced sales-to-listings market, gives us hope that Canada will experience a soft landing rather than a severe correction in prices.

A recent article in the Globe and Mail by Scott Barlow supports the soft landing thesis. Referring to research by Carman Reinhart and Kenneth Rogoff, Barlow points out past global housing crashes were preceded by three factors: rapid price growth in housing prices and domestic equities, declining per capita GDP and a slowdown in exports.

While Canada’s exports have slowed and our per capita GDP certainly hasn’t been anything to write home about, it has been increasing. House prices may feel like they have been soaring, but nationwide, they have only increased 13% over the past four years compared to increases of over 20% in the four years before previous housing crashes.

Of course living in Vancouver, we have experienced much greater increases and sales and prices look to be under more pressure. In March, Vancouver area home sales were off 18% year over year, but prices were only off 3.9%. West side prices were off 9.1%, but this is relative to a pretty hot market last year.


Lower exports of metal and non-metallic mineral products were the main reason for the increase Canada’s trade deficit in February.

MMC-2013-03 Trade Balance

A stronger U.S. economy and higher oil and gas prices should help return Canada’s balance of trade back to a surplus in future months, however current trends could result in downward pressure on economic growth in Canada in the near term.

Let us know what you think of March’s market activity in the comments below!


1. NWM fund performance is net of fees and expenses. Past performance is not indicative of future returns
2. Market indexes are provided for information only. Comparisons to market indexes have limitations because the indexes have material characteristics that differ from the NWM’s investment program. NWM does not invest in all or necessarily any of the securities that comprise the market indexes. In addition, investments made by NWM may have different levels of risk. Reference to the market indexes does not imply that NWM will achieve returns similar to the indexes.  
3. This document is not intended to provide legal, accounting, tax or specific investment advice. Please speak to your advisor regarding your unique situation. Information contained in this document was obtained from sources believed to be reliable; however Nicola Wealth Management does not assume any responsibility for losses, whether direct, special or consequential, that arise out of the use of this information.