Highlights This Month
- Poor finish in July for global equity markets.
- Should we be expecting markets to fall?
- U.S. economy continues to show signs of accelerating.
- Why the extended rally in stocks and increased price of bonds?
- Market volatility will likely increase.
- Chinese economic growth continues.
- Will weak economic growth in Europe lead to deflation?
- Good news for job market recovery.
- Wage growth remains weak.
- Consumer confidence index hits highest level since 2007.
- A stall in U.S. housing.
- CANADA’S employment numbers weaker than expected.
- No sign of decline for Canadian housing market.
The NWM Portfolio
Returns for NWM Core Portfolio were up 1.2% for the month of July.
The Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.
Returns were mixed in July with risk assets selling off near the end of the month.
Interest rates continued to move lower last month. While 2-year Canada yields were virtually unchanged and ended the month at 1.10%, 10-year Canada’s rallied and ended the month at 2.16% versus 2.24% at the end of June.
NWM Bond was up 0.4% in July with all our managers contributing positive results during the month. This is a good result, because not only did government bonds sell off during the month, but credit spreads widened.
High yield bonds generally performed poorly in July as credit spreads in the U.S. widened near the end of the month.
Because government bond yields actually declined, the current correction in high yield bonds is different than the correction last year in that investors appear to be concerned with credit risk rather than interest rate risk.
While we believe the high yield bond market is expensive and over-bought short term, we do not believe defaults are set to move higher and thus suspect the recent correction in U.S. credit spreads is of a short-term nature.
NWM High Yield Bond actually managed to increase 0.5% in July with the BMO Guardian High Yield leading the way, up 1.4%, followed by Picton Mahoney up 0.2%.
BMO U.S. High Yield (Montegy) was down 1.0% and PHN was down 0.4%.
Because the Canadian dollar declined over 2% versus the U.S. dollar during the month, managers who did not hedge their U.S. dollar currency positions benefitted during the month.
Also, credit spreads in Canada did not widen as much as in the U.S., so Canadian high yield issues performed better than in the U.S.
Global bonds were stronger, with NWM Global Bond increasing 1.3%. The weaker Canadian dollar likely contributed to these returns.
The mortgage pools continue to deliver steady returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.4% and 0.6% respectively for July.
The preferred share market was up marginally for the month of July as the iShares S&P/TSX Preferred Share ETF increased 0.14% and the BMO S&P/TSX Laddered Preferred Share Index ETF was up 0.29%. NWM Preferred Share gained 0.49%.
One of the key drivers of the outperformance for the month was our overweight position in Bell Aliant. The move by BCE to acquire the remaining shares of Bell Aliant from public shareholders led to the preferred shares trading $2 higher with the improved credit outlook.
Canadian equities were strong in July with the S&P/TSX gaining 1.4% (total return, including dividends), while NWM Strategic Income was up 2.1% and NWM Canadian Tactical High Income was up 1.4%.
Foreign equities were generally stronger in July with NWM Global Equity up 1.3% versus 0.6% for the MSCI All World Index and 0.7% for the S&P 500 (all in CAD).
Of our external managers, Carnegie and BMO Asia Growth and Income were up 1.6% and 3.9% respectively, while Templeton Smaller Company, Edgepoint and Cundill fell 1.2%, 1.0%, and 0.3% respectively.
NWM U.S. Tactical High Income returned -0.7% in USD (approx. +1.5% in CAD) with 22 puts and 8 calls written on existing positions. The Fund has also written put options on a notional 62% of the fund.
The REIT market was stronger again in July, with NWM Real Estate up 0.7%.
NWM Alternative Strategies returned approximately 1.0% in July (this is an estimate and can’t be confirmed until later in the month) and gold declined 3.4%. Meanwhile, NWM Precious Metals was up 0.7%, as gold stocks continue to outperform gold bullion.
July In Review
On a price only basis, the Dow Jones Industrial Average actually dipped into negative territory for the year.
Canadian equities managed to deliver a positive return, but like most global exchanges, a poor end to the month helped dampen what was looking to be a strong July.
Up until the end of the month, markets had been unusually calm, with volatility in the first half of the year, as measured by the CBOE Volatility Index (aka the VIX), registering its lowest reading since 2007.
Even more unusual, all asset classes (stocks, bonds, and commodities), had been moving higher.
The last time markets started the year with asset classes all heading in the same direction was 1993.
A debt default in Argentina and a banking crisis in Portugal are definite concerns for these respective economies, but less so for the global economy.
Military conflict in Iraq, Gaza, and the Ukraine could all have huge potential impacts and warrant close attention.
In particular, the situation in the Ukraine and resulting economic sanctions levied against Russia have the potential to materially impact the fledging European economic recovery. Historically, however, the market has tended to disregard geopolitical events.
Ned Davis Research recently pointed out that over the past 100 years, while U.S. equity markets may have declined 2.9% on the first day of a crisis, they have gone on to rally 4.6% during the following 30 days.
Wall Street strategists actually have a reputation for being too optimistic when making market forecasts. It’s good for business. People tend to buy more stocks when you tell them the market is going up.
Over the past three years, however, Wall Street has been too bearish as the market has exceeded their forecasts, and 2014 is no exception. Perhaps they are too focused on the 6 o’clock news.
Is the market’s optimism justified? With valuations stretched, further gains will need to come from higher corporate earnings, and this is looking more promising.
While it’s not unusual for companies to exceed earning expectations, the quality of the beat witnessed in the second quarter is encouraging.
Typically, companies talk down their estimates so as to report better-than-expected earnings. Under promise and over deliver, it’s an old Wall Street trick.
During the past four quarters, S&P 500 companies lowered their earnings estimates by an average of 6% in the weeks before results were announced with 70% of companies subsequently beating estimates.
With three-fourths of firms having reported second quarter earnings, 70% have again beaten estimates, but this is off analyst projections that had fallen only 3.5%.
Also, revenue growth is expected to be up 4.3% year over year, which according to Thomson Reuters is the biggest gain in sales since the first three months of 2012.
Companies have a few levers to pull in order to “influence” earnings, but sales are harder to play with.
The U.S. economy continues to strengthen, and to some extent the same can be said about Europe, China, and Japan. Oh, and Canada as well.
We will talk about all of these regions in more detail below, but the direction of the global economy is favorable for U.S. stocks and is one reason it’s been three years since the U.S. markets have suffered a correction in excess of 10%.
Central Banks, and the U.S. Federal Reserve in particular, have kept short-term rates near zero for almost six years and investors have learned not to “fight the Fed,” or the ECB, or the Bank of Canada, etc…
But if the economy continues to recover, interest rates will begin to move higher. When and how much is the key question.
The Federal Reserve, which is presently the odds on favourite to be the first central bank to raise rates, is guiding towards mid-2015 for the first increase in the short-term interest rates.
Assuming this is correct, the next question, and probably the most pertinent for the capital markets, is: how quickly does the Federal Reserve make subsequent increases? The market views a normalized or neutral policy translating to a 4% Fed funds rate.
Is this where we are headed? Unlikely any time soon.
While the labour market, as measured by the unemployment rate, has improved faster than the Federal Reserve’s forecasts, GDP growth is still sluggish. Inflation has moved up slightly, but wage growth remains negligible.
No wage growth means no inflation, and this lack of inflation enables the Fed to keep interest rates lower for longer.
In fact, a recent Wall Street Journal poll found 79% of participating economists believe there is a greater risk the Fed raises rates too late as opposed to raising too soon.
It’s only when interest rates rise to the point of chocking off economic expansion that the market starts to correct.
This is usually evident in an inverted yield curve. We are nowhere near this point, and don’t expect this to happen in the near term.
If wage inflation picks up, however… well, all bets are off.
Beijing’s efforts to shore up the Chinese economy appear to be working as China’s industrial production increased 9.2% year-over-year in June and the HSBC Purchasing Managers Index increased to 51.5 in July, firmly in expansion territory.
Concerns persist around the health of the domestic housing market and private sector debt, but China’s new government has so far proven they still have the fire power to keep the economy growing, regardless of what happens in the rest of the World.
Investors have started to notice, pushing the Shanghai Composite up nearly 9% in August. Chinese stocks have lagged over the past year and valuations look attractive.
Investors have been less kind to European stocks, which were down almost 2% in July and continued to move lower in early August.
The situation in the Ukraine is obviously one of the reasons, but it’s not the only reason. The best one can say about the economy in the Euro-zone is that it has stabilized.
While second quarter GDP grew 0.6% in Spain, Italy’s economy contracted for the second quarter in a row, which, barring any positive revisions, means Italy’s economy has slipped back into recession.
Also, the OECD’s (Organization for Economic Cooperation and Development) leading indicator index for Germany has weakened; this indicates growth in Germany will remain weak over the next several months, leading some to suggest GDP could even contract in the second quarter.
The June unemployment rate rose in France, Austria, and Finland and inflation hit a new low of 0.4% in the Euro-zone as a whole in July.
The Euro has finally started to weaken, however, and the resulting higher import prices should help move inflation higher. A weaker Euro could also help make European exports cheaper and lead to higher economic growth.
Euro-zone manufacturing strengthened in July with the Markit purchasing managers indexes for both manufacturing and services matching a three year high of 54.
As we said, stable is the best we can say.
Overall, a rebounding U.S. economy is key for the markets. Higher interest rates are a threat, but as long as wage inflation remains subdued, the Federal Reserves will be slow in taking action.
Any help from China or Europe is a bonus. Volatility should move higher, but we don’t expect the sell-off in equities at the end of July to be indicative of a major correction.
The U.S. Economy
Second quarter GDP grew a more than expected 4.0% while first quarter growth was revised up to a 2.1% contraction versus the previously reported 2.9% decline. Taken together, the results add up to growth in the first half of the year of about 1.0%.
The 4% increase in Q2 GDP was good news and a decent bounce back from an awful Q1. Almost 1.7% of the increase, however, was a result of businesses restocking and inventory building.
If sales do not materialize, we could see the U.S. economy give back some of this gain in future quarters.
Most economists believe the U.S. economy should deliver growth in the second half of the year of about 3% resulting in full year economic growth of 2%, about on par with GDP growth the past few years.
In other words, below average.
Leading indicators and manufacturing indices continue to point towards stronger business activity, but we are just not seeing it in the numbers yet.
For the first time since 1997, the U.S. has added more than 200,000 jobs in six consecutive months and the 244,000 monthly average is the highest since early 2006.
Confirming this strength, jobless claims in July hit their lowest levels since February 2006 and are presently at levels consistent with monthly job growth in excess of 200,000.
The number of job openings in the U.S. hit a 13-year high of 4.7 million at the end of June and 2.53 million workers quit their jobs in June, the most since June 2008. Both suggest the U.S. labour market is becoming stronger and more flexible.
Typically, workers voluntarily quit a job only when they are confident they will find a better one. The Challenger Job-Cut report increased in July, but this was almost entirely due to layoffs at one company, Microsoft.
Also, while the unemployment rate moved up slightly, it was only because of more workers entering the workforce, as evidenced by the one tenth of a percent increase in the participation rate.
It’s hard for consumers to really get ahead when wage growth is barely keeping up with inflation. But this might be about to change.
The Labor Department reported in June that the Q2 labor cost index increased at its fastest rate in six years, increasing 0.7%.
Some of the increase could reflect payback from an unusually weak first quarter, however, as the year-over-year increase was only 2% and in line with recent trends. For reference, the employment-cost index increased 3-4% before the recession.
Backing up the theory that wages could be set to rise, the National Association for Business Economics’ latest business conditions survey indicated 43% of participating economists revealed their respective firms had already increased wages and for the first time since October 2012, no respondent indicated their firm had reduced wages.
The National Federation of Independent Business’ compensation survey has also been rising since late 2013 and is presently near a six-year high.
Employment, particularly wage inflation, is a key variable to watch in order to determine the timing and frequency of future interest rate increases by the Federal Reserve.
Over the past few months, Wall Street has started to focus on the potential re-emergence of inflation and the thesis that the Federal Reserve is behind the curve in addressing the issue and should begin to normalize monetary policy.
We highlighted some early signs of wage inflation above, which is necessary in order to get increased inflationary expectations, but the broader economy has also started to indicate inflation has stabilized and could soon turn higher.
Deutsche Bank, for example, recently suggested current industrial capacity utilization rates are comparable to inflation closer to 3.5%.
We would suggest industrial capacity utilization rates might be overstated given a portion of current industrial capacity is likely redundant, but some increase in inflation should be expected as the economy recovers.
Concerns about wage inflation and capacity utilization notwithstanding, commodity and price inflation actually inched lower last month.
One of the reasons for the decrease was food prices – which have been on the rise in recent months – took a bit of a breather in June, posting its slimmest month-to-month increase since January.
Lower grain prices due to bumper corn and soybean crops could filter through the food chain over the next few months and may impact headline inflation numbers.
We would expect this to be more of a one-time hit, however. Wage growth and the impact of higher housing costs due to increased rents are of more concern to investors.
Helping drive consumer moods higher is a belief the job market has turned and will lead to fattened paycheck.
Offsetting some of the optimism around employment is the housing market recovery, which has cooled.
While consumers may say they’re in a better mood, their actions say otherwise.
Retail sales in June registered their smallest gain since January and capped off a sluggish second quarter that began with a slow start to Spring and never seemed to get on track.
June is typically a clearance month, but retailers appear to be discounting goods even more than normal.
The bigger concern is the sluggish retail environment carries over to the important back to school shopping season.
A recovery in new and existing home sales is important for economic growth because its impact extends well beyond the housing market itself, which alone has historically accounted for 5% of the U.S. economy.
Momentum in the housing market recovery has stalled in 2014, however, as construction and sales of new homes have disappointed. June was no exception as new home sales plunged over 8% versus a May number that itself was revised lower.
Housing starts and permits were also disappointing with both higher than June 2013, but sharply lower than last month.
Much of the decline was due to a 30% drop in the southern part of the country and is likely attributable to an unfortunate stretch of wet weather.
Higher prices, lack of product, and availability of credit are all likely contributing factors to the sluggish housing market.
Where we did see some improvement in June was existing home sales, which increased over 2% versus the previous month, but is still down versus the previous year.
Most of the decline from last year can be attributed to a decline in the sale of distressed homes, which are down almost 40% compared to last year.
Fewer foreclosures are a sign of a healthier market and have helped contribute to the increase in prices, but have also resulted in fewer homes available for sale, especially ones at bargain prices.
Increasing prices have the further impact of reducing the inventory of homes available for sale by convincing potential sellers to hold off listing their home in hopes of getting a higher price at a later date.
We still have faith in the housing market recovery. A recovering job market should help.
The U.S. trade deficit in June contracted at its fastest pace since November as imports declined over 1%.
The unexpected decline in imports could result in second quarter GDP being revised higher as imports will be a smaller drag on output. The offset to this, however, is declining imports is usually a sign of a weak domestic economy.
The better job market is being partially offset by a disappointing housing market. Overall, however, we continue to see signs that the U.S. economy is moving in right direction.
The Canadian Economy
Strong May GDP growth puts Canada’s economy back on track to grow in the range of 2.5% in 2014. The strong showing for the U.S. economy in Q2 further reinforces this trend given 75% of Canada’s exports head south of the border.
A week later, however, Statscan reported human error resulted in the incorrect processing of some data and the real increase in July was 42,000. While this is a welcome relief, that fact remains employment is no longer the good news story it was a couple of years ago.
Over the past year, Canada has added 156,800 jobs, or a 0.9% increase, but the quality has been weak with over 75% being part time.
Headline inflation increased at its fastest pace in 28 months in June, but core inflation remains below the Bank of Canada’s 2% target rate.
Food prices were a major reason for the stronger headline number, increasing 2.9% year-over-year.
Because most of the drivers of the higher headline number are considered temporary, inflation concerns are unlikely to alter the Bank of Canada’s current monetary policy of stable short term rates.
Auto sales continued to drive consumer spending higher in May.
We still expect, however, that the Canadian consumer’s higher debt level will weigh on spending in future months and provide a headwind for economic growth.
Forecasters in Canada, and abroad, have highlighted Canada’s housing market as one of the most overvalued in the world and have continually forecasted its demise.
Canadian stocks that were judged to be exposed to the domestic housing market became short selling targets of global hedge funds.
And yet the Canadian market continues to keep calm and carry on.
Prices, in fact, hit a record high in May according to the Terenet National Bank Index. Even Vancouver prices continue to show no sign of fatigue, with greater Vancouver prices up 4.4% year-over-year in July and the Westside up 9.9%.
Canadian housing starts and permits were also up, which bodes well for economic growth.
We’ve given up trying to call a top.
Like the U.S., Canada’s balance of trade took a turn for the better in June, delivering a trade surplus nearly $1.9 billion. This is the largest trade surplus for Canada in two and a half years.
Exports led the way, increasing 1.1% versus May, while imports declined 1.8%, the largest decrease in 18 months.
While over 75% of Canada’s exports are shipped to the U.S., and we would expect a stronger U.S. economy to help increase Canadian exports in the near term, it was actually non-U.S. export demand that drove the trade surplus higher in June. This bodes well for second quarter GDP growth.
The numbers don’t look too bad, but it just feels like the Canadian economy is losing momentum. A better U.S. economy should help.
Let us know your thoughts on July’s market activity in the comments below!This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.