BY SEAN OYE, CFP, CFA
Highlights This Month
- THE TWO GIANTS CAUSING MARKET VOLATILITY: CHINA AND THE FED
- THE YUAN TAKES A STEP BACK TO STEP UP TO THE BIG LEAGUES
- CHINESE FIRE DRILL: WHAT CHINA IS DOING TO TRY TO REVIVE GROWTH
- AND SO WE WAIT…THE FED DELAYS AN IMMINENT RATE HIKE
- A PERFECT STORM IS BREWING FOR BONDS
- U.S. UNEMPLOYMENT IS THE LOWEST SINCE 2008
- WEARY AMERICAN CONSUMERS CELEBRATE INCREASED WAGES – AND SPENDING
- THE HOUSING MARKET WAS VARIED THROUGH Q3 BUT SHOWS PROMISE
- CANADA’S EMPLOYMENT NUMBERS LOOK GOOD…BUT ARE THEY?
- MIRRORING REAL ESTATE PRICES, WESTERN CANADIANS LEAD CONSUMER CONFIDENCE POLLS
THE NWM PORTFOLIO
NWM Core Portfolio declined 0.43% in September. NWM Core is managed using similar weights as our model portfolio and is comprised entirely of NWM Investment Pools and Limited Partnerships. Actual returns will vary depending on specific client situations and asset mixes.
Both NWM Primary Mortgage & NWM Balanced Mortgage produced positive results up +0.30% & +0.49% respectively.
NWM Bond returned -0.38% vs. the DEX Short-Term Bond Index -0.35%. All of our managers except RP Fixed Income Plus posted a negative return from their credit exposure as interest rate risk is not high as our managers are short duration.
NWM Global Bond was down -0.67%. All underlying managers posted negative returns in their base currency; however, PIMCO Monthly Income Fund posted a slightly positive gain of ~7bps when you translate the returns to Canadian dollars. Our managers are positioned conservatively on the duration side and are keeping cash levels higher than normal. Templeton is at an essential 0 year duration, PIMCO has a higher duration of ~3 years, but this is mainly due to an Australian interest rate swap; essentially, they are betting on the Reserve Bank of Australia to reduce rates as China slows.
NWM High Yield Bond was down 1.27%. All managers were in negative territory as credit spreads blew out (see below) across the broad market from a combination of factors such as China slowing down, the Fed interest rate hike, and a huge supply of new issues with some having a hard time to price and size. The strength of the U.S. dollar helped the Fund as it has ~48% U.S. dollar exposure.
The credit market started to breakdown in late June, and continued into August and September when the real capitulation in the credit markets took hold. August saw a high yield technical development; Templeton had a huge impact on the high yield market due to it selling a significant amount of bonds. The street knows that Franklin Templeton has been in net redemptions and needs to liquidate bonds; any bonds that Franklin owns are being heavily discounted. In terms of current credit spreads, Canada spreads are now at 850bps up from 550bps in June and U.S. spreads are up to 650bps from 450bps in June.
The preferred share rate reset market was down -6.0% for September versus the NWM Preferred Share which was down -5.5%. Two new deals were announced during the month with mixed reception. RBC came to the market with a perpetual preferred shares via a bought deal and was met with low demand. The deal eventually needed to be re-offered to help brokers clean up their books. Brookfield Asset Management (BAM) also came to market and was well received. BAM is the second issue with a yield floor, offering a minimum 5% yield protecting investors in the scenario that Government of Canada bond yields are lower in 5 years.
NWM Real Estate was up 1.23%, generally in-line with the S&P/TSX Capped REIT Index (+1.57%). A combination of a low rate environment (some economists expect another Bank of Canada rate cut next year) and sector rotation (materials and energy in the doghouse) has benefited this subsector of financials.
Canadian equities were weaker in September with the S&P/TSX Composite down -3.67% (total return) and the energy, materials and healthcare sectors dragging down the Index. NWM Canadian Equity Income on a relative basis performed quite well as the Fund was down -1.75%; this was mainly attributed to the Fund being underweight in the three aforementioned sectors (energy, materials and healthcare) vs the benchmark.
NWM Canadian Tactical High Income was down -2.26% for the month versus the S&P/TSX down -3.67%. For the year, the Fund is down 1.96% versus the S&P/TSX down 7.02%; that is over a 5% difference in return. In September the biggest detractors were the energy and material names, more specifically, Methanex and West Fraser Timber. Both companies have solid free-cash-flows and continue to buy back their shares at these depressed prices; we still like these names long-term. No new positions were added last month in terms of long-only, but we did write a significant amount of “put” options to take advantage of the high volatility (wrote further out-of-the-money and longer terms). We may consider increasing the high yield portion of our cash float as the spreads are over 700bps; we currently have ~4.1% in high yield bonds. The estimated annualized yield is approximately 9.29%.
Foreign equities were also weaker in September with the MSCI All Country World Index down -2.22% (total return basis in Canadian dollars). NWM Global Equity was down -2.77% in September. The returns were dragged down by Edgepoint/Cymbria and Lazard Global Small Cap. BMO Asian Growth & Income Fund was the worst performer in August but has been the best performer in the Fund in September (-0.30%). Our new manager, Value Invest, was the 2nd best performer coming in at -0.78%; this was a good result for a value manager considering that Mackenzie Cundill Value (manager we changed in mid-August) had a return of -5.36% last month. We have just over 50% of NWM Global Equity in U.S. dollar assets which has been a tailwind for the Fund this month and year-to-date.
NWM U.S. Tactical High Income returned -1.86% against -2.47% for the S&P 500. Being underweight, the worst performing sectors last month (health care, materials & energy) helped relative returns. The significant amount of “put” and “covered calls” positions coming into the month helped dampen the volatility and downside during the month. We have become more defensive by writing further out-of-the-money “puts”. The current estimated annualized yield on the Fund is ~10%–almost spot on with our trailing 12 month distribution yield.
NWM U.S. Equity Income returned -3.22% (-2.47 in Canadian dollars). Financials were the biggest detractor for the Fund on both an absolute and relative basis—this makes sense, the impact of the Fed not raising rates on banks and asset managers. Exxon Mobil Corp was the one new position added last month. The Fund is approx. 7% covered down from 10-12%.
NWM Alternative Strategies returned +1.74% in September. This is an estimate and can’t be confirmed until later this month; the big driver was Winton (trend-follower strategy) which was up ~4.7%.
NWM Precious Metals Fund returned -4.08%. The detractor was the Sentry Precious Metals Growth Fund (approximately 62% of the Fund) which was down 4.20% in September after posting a solid 5.62% return in August. Security selection detracted as the underlying gold bullion price initially spiked up following the mid-September Fed meeting then pulled back and was only down ~-1.77% (-0.14% Canadian dollars) for the month. The Bullion (Silver & Gold) Fund/ETFs produced better relative returns and some of our ETFs (Central Gold & Sprott Physical Silver) produced positive returns in Canadian dollars.
The last few months have not been kind to equity markets. August in particular was a volatile period with the S&P 500 sinking 11.23% by August 24 only to bounce back and mitigate some losses finishing the month at -6.26%. The Dow Jones Industrial Average sank over 6.4% in August— claiming the title for the worst August since 1998! The S&P/TSX Composite followed a similar rollercoaster ride and finished down -4.21%. The month of September was not much better with the S&P 500, DJIA & S&P TSX Composite down -2.47%, -1.35% & -3.67%, respectively. If you ascribe to the Stock Traders’ Almanac, you wouldn’t be surprised by September’s negative returns. Historically, September is the worst month for stocks.
Since 1896 the Dow Jones, on average, declined 1.06% in the month of September in contrast to an average gain of 0.75% among the remaining months. If history is on our side, we would expect a bounce back and return to a positive month in October.
Besides the last two months, it has been a pretty calm market. We’ve experienced 47 months where the market didn’t show a 10% correction; this is the third longest span in market history, the longest being from 85 months (October 1990 to October 1997).
Are 10% corrections out of the norm? Not really, since the financial crisis ended, the S&P 500 had experienced negative 10% plus intra-year periods 5 times. Remember the Eurozone debt crisis in 2010, the U.S. credit downgrade in 2011? The “taper tantrum” in 2013? You get the point.
In fact, in the last 35 years, the median intra-year decline has been 10.7% and over that same period of time, we’ve only experienced 3 times when the full year’s losses were greater than 10%. We know this may be hard to stomach for some readers, but every year we should expect at least a 10% intra-year correction; however, this is not the same as saying we’ll finish the year in negative territory.
Let’s turn back the clock to October 19, 1987, this is the day the market dropped an astonishing 20% (down 34% peak-to-trough). Everyone invested in the market thought the world was going to end, what most people don’t remember is that when 1987 drew to a close, it was actually up 2% for the full calendar year.
Bottom line, staying invested during tumultuous times may test your emotions, but successful long-term investors are able to block out the short-term noise and focus on the long-term fundamentals. Over the last 25 years, if an investor that remained invested in the S&P 500, even during the tech bubble collapse and financial crisis, would have earn a ~9.2% annualized return; whereas, missing just the 15 best days (out of the 9,000+ days) would have reduced the annualized return by ~42% to 5.3%.
The increase in market volatility over the last few months can be attributed to two main actors, namely, China and the Fed. From China, the unexpected Yuan currency devaluation, the fears that the world’s second largest economy is not meeting official growth estimates, and potential setbacks on market reforms are all contributing to the uncertainly. The icing on the cake is the insecurity around the Fed rate decision and its impact on the global re-pricing of risk.
THE CHINESE ECONOMY
What really spooked the markets in August was when China surprised the world and devalued the Yuan by 2%–biggest single-day fall in the Yuan since 1994. Many viewed this as a sign that the government is trying to revive its flagging economy and worried this could be the start of a global currency war.
A Texas-based hedge fund manager, Mark L. Hart III, is betting that the Yuan will drop 50% more as he believes foreign investors will start pulling all their money out of China due to the fear that the strength in the U.S. dollar will cause emerging-market currencies to continue to plunge. Adding to this sentiment, is the knock-on effect of an increase in corporate defaults and a general unwinding of the carry-trade that has been going on since the Fed began it’s QE program. But as we know, timing is everything. Mr. Hart has had this view since 2010 and it has yet to pay off. This past June, he closed his Chinese fund just before this devaluation.
We don’t believe Mr. Hart’s prediction will happen anytime soon as the Chinese still have over $3.4T in FX reserves (mostly U.S. treasuries) which they have been using to help stabilize their currency.
Furthermore, we also don’t believe China’s initial currency devaluation was aimed at boosting its exports by making the currency more competitive. China wants to graduate to the big leagues and be recognized by the International Monetary Fund (IMF) as an international reserve currency (Special Drawing Rights status) and in order to do so they would need to make their currency more market-based and freely usable.
The long-term benefits of inclusion would include having more central banks holding reserves in Yuan which would stabilize its value and, more importantly, being able to buy commodities and other goods in yuan. The IMF is expected to have a review of Special Drawing Rights (SDR) basket by year-end and it is one of the reasons Beijing is pressing so hard on its reforms (e.g. changing the way they report GDP to meet IMF standards; historically, NBS just released economic growth rates, but now will release the economic output each quarter also).
Besides the currency move, everyone is concerned about China’s economic slowdown but, should we really be surprised? An economy cannot grow at double-digit rates in perpetuity. The Chinese government has been telegraphing the last couple of years of moving its economy from an export/infrastructure led economy to a more domestic-consumption growth economy which will result in short-term disruptions in growth but should also lend itself to more stable growth (less dependent on gov’t funding and external markets) in the long-term.
Some believe that China’s stock market meltdown earlier in the summer was a precursor to China’s deteriorating economic conditions. As we’ve mentioned in previous commentaries, the significant swings in the mainland Chinese stock markets should not be viewed as a crystal ball to the economic situation in China. To illustrate this point we only have to look back a few years when Chinese GDP was growing between 7.7-10.6% during the 2010-2013 period while stock prices fell ~35% over that same time frame.
When you read or hear about the Chinese stock market in the media, you need to remember that, unlike North American exchanges, when stock boards are red that actually means shares are rising (red is a lucky color in China); green means share are falling. The composition of investors in the Chinese stock markets are mostly made up of retail investors and speculators; there were 56 million new trading accounts opened in the first 6 months of 2015!
Hmmm, I wonder if President Xi’s anti-graft campaign moved gamblers from Macau to the stock markets as the gambling revenue plunged 36% and revenue fell for the fifteenth straight month, which coincides with money flowing into the stock market.
Anyway, it appeared that the average Chinese investor did not care much about the extremely high valuation multiples paid during the euphoric Chinese market run-up; this was not much different from the tech bubble mania in the late 1990s where any stock related to the technology and/or the internet was expected to make investors millions.
We all know how that story played out, the NASDAQ appreciated ~156% in the two years leading up to the March 2000 peak and subsequently fell 75% to find a bottom in September 2002; at its peak the price-to-earnings multiple was at 175 times! China’s version of the NASDAQ is the ChiNext Composite Index (tech-heavy) appreciated even more (296%) and was trading at 146x earnings at its June 3, 2015 peak.
As of September 30, the P/E is still at 78 and the market has sold off only ~41%, but clearly the losses would have been greater without government intervention (allowing companies to halt shares, going after short sellers, banning major shareholders from selling stakes, etc.).
Now, back to the real economy. Sure, we all know the Chinese economy is still struggling in the manufacturing sector which has been in contraction territory since beginning of the this year’s second quarter; however, August and September numbers could be lower than normal as many polluting-factories were shut down to make for blue skies for a WWII military parade and also the work related stoppages from the Tianjin blast.
On the positive side, the service sector, consumer (retail sales still in double-digits) and housing has shown some strength. In fact, new home prices rose month-over-month in August in 35 out of 70 cities, compared with 31 cities in July. Domestic consumption continued to head in the right direction, contributing 60% of economic growth in the first half of 2015, up from 51.2% in 2014. This is a good sign as China wants to continue increasing domestic consumer consumption to develop world levels.
Currently, the Chinese government has a few fires to fight (stock market and slowing GDP growth). We are not sure how they will fare with the stock market but for the real economy they still have many levers to pull in terms of fiscal and monetary policy.
Here are a few things China has done over the last two months to try and revive growth:
- In August they boosted fiscal spending by 26% over the prior year which should start to show in growth numbers in a few months.
- They have taken back 1-trillion Yuan from local governments who failed to spend their budget allocations and will reallocate this capital. Some have speculated that the anti-graft campaign has forced some local officials to reign back spending to avoid suspicion.
- China helped their local governments’ alleviate some of their debt burden by increasing the debt swap lines from $2-trillion to $3.2-trillion. Local government debt was at $15.4-trillion at end of 2014 from 10.9-trillion six months earlier.
- They allocated $60-billion Yuan for a SME Development Fund and also expanded tax reductions for private businesses. This will stimulate growth in employment since private companies account for 80% of all employment. 30 years ago there were no private companies, hence, employment growth was driven by the government).
- China removed quotas for companies to raise funds overseas, by removing the quotas, China wants to encourage more borrowing overseas to fund local initiatives.
- China’s central bank cut the minimum home down payment required of first-time buyers for the first time in five years, from 30% to 25%.
- The central bank has cut the benchmark interest rate by 25bps to 4.6% in late August in order to make borrowing cheaper domestically; this is the 5th time they have cut rates since last November. A few days later, the People’s Bank of China also cut the bank reserve requirement by 50bps which pumped more liquidity into the domestic market.
Any positive/negative economic data points tend to cause swings in the commodity markets as China is still the largest buyer. With 20% of the world population and 13% of world GDP, it is quite astonishing to see the huge proportion of various commodities China consumes—they consumed more concrete in the last 3 years than the U.S. did in all of the 20th century!
Living in Canada, we have felt China’s impact on our base metal and energy sectors. All other major commodity exporting countries have been hurt as well with their governments grappling with the fallout (e.g. Brazil is a complete mess with the Real hitting a 13 year low and dropping approximately 33%, inflation over 9.5% and notable political turmoil).
China’s slowdown might hurt certain sectors of the economy more than others but in aggregate it should not have any significant impact, besides market volatility, as the U.S. has a more domestic-oriented economy which relies less on exports. China only represents ~0.7% of U.S. GDP in terms of exports, not really meaningful (Canada is a 2.5x larger trading partner).
China will have an indirect impact on the U.S. importing deflation given the aforementioned comments about China being a commodity juggernaut). Corporate America is not as exposed to China as most people would think. The S&P 500 companies have very low revenue exposure to China at only 1.6%. The sectors most exposed are technology and consumer discretionary names (e.g. gaming names have been hurt, particularly Wynn which has ~70% of revenues tied to China).
Overall, we think the currency devaluation was a necessary step for China’s path of reform and not the beginning of a currency war. We are not expecting a sharp turnaround in China’s growth back to over 7% anytime soon, but we do think they should be able to stabilize to approximately 6.5-7% growth range over the next few years. Stabilization would be welcome news to an already nervous market and also to the commodity-rich countries that heavily rely on purchases from China.
Ok, the Fed didn’t hike rates, but we know they will, most likely in the December Federal Open Market Committee (FOMC) meeting. The “dot plot” shows where each of the 17 members of the FOMC expects rates to be over the next few years. The Fed president from Minneapolis is projecting the Fed funds rate to go below 0 before year-end; I don’t think he really believes this but he probably just wants to make a point.
The median estimates have been revised down since the last plot chart in June. Median estimates for 2015, 2016 & 2017 are now expected to be 0.40%, 1.375% & 2.625% versus prior estimates of 0.60%, 1.625% & 2.875% respectively.
On September 30, the markets opinion, based on the Fed’s fund futures, expects only 41.2% probability that the Fed will increase rates in December to 0.50% or greater. On October 2, after weak non-farm payrolls came out, the probability dropped to 33.4%! So far, the market has been right, but we believe that they will be wrong. This December, based on Chair Yellen and the other FOMC members’ comments post September’s rate decision to keep rates on hold.
The Fed members tend to be a cautious bunch and don’t want to make the same mistakes they made during the great depression. Back in 1936 (7 years after 1929 crash), they tightened monetary and fiscal policy too early, it stunted the recovery and the U.S. fell into it’s third worst recession of the 20th Century.
The Fed had to reverse policy which went on to ease beyond the end of WWII. In fact rates on 3-month T-bills stayed sub-2% all the way until December 1952. It wasn’t until September 1958 where you saw a sustained 2%+ level in short-term rates.
The reason the Fed decided to not raise interest rates (have been at near zero since December 2008) was most likely due to global events (i.e. China). Some economists believed they were using the recent volatility in financial markets as an out. When the FOMC stated that “recent global economic and financial developments may restrain economic activity somewhat,” you know they were referring to China and other emerging markets. Going forward, Fed observers may put more weight on global market events versus the Fed’s original dual mandates of price stability and employment.
Randall Stephenson. AT&T’s CEO and Chairman of the Business Roundtable – a group of top executives of some of the largest companies in the U.S., said “…we can’t control international markets, but we can control our own variables.” In regards to the Fed raising rates a quarter point, he said that it is “not going to have an effect on how CEOs invest and hire over the next 12 months.” Businesses and the markets dislike uncertainty and by not raising rates this has caused some angst among investors and execs.
What is interesting is the Fed’s accompanying statements which still describe GDP growth as “moderate” and the low inflation rate is described as transitory effects due to the stronger dollar and lower commodity prices. The Fed’s preferred gauge of inflation has remained under its 2% target since April 2012 and was only 1.3% in September. The FOMC reduced their median forecast for inflation in 2016 and 2017 by 10bps to 1.7% and 1.9% respectively, but we know the Fed has a poor track record of predicting the future.
Nothing has changed in terms of their view on the labor market; in fact, it is at the low end of their full-employment target. The Fed seems comfortable allowing the unemployment rate to undershoot its objective, hence, the non-farm payroll report may lose some of its potency we’ve grown accustom to in recent years.
A lot of speeches came out after the Fed meeting with 13 of 17 officials thinking that rates will rise later this year; none more important than a late September speech by Chair Yellen, when she delivered a perceived hawkish message when she pulled back expectations into 2015 for a first rate hike, but a government shutdown or a debt ceiling stand-off could change those plans.
Looking at the major tightening cycles that started in February 1994, June 1999 and June 2004, we have seen the U.S. market as measured by the MSCI US Index go up to mid-single digits in the first 6 months after the initial rate hike on 2 out of the 3 occasions. The MSCI World ex-U.S. did even better posting positive returns for the 3 aforementioned periods.
This time may be no different as the U.S. economy continues to grow with rates still at ultra-low levels. That being said, the upside could be capped due to a squeeze on profit margins from a stronger U.S. dollar and the tightening labor market. Developed markets ex-U.S., such as Europe, may tend to do better as the European Central Bank (ECB) ramp up their quantitative easing program, which has the effect of weakening the Euro, helping exports while importing some inflation.
Overall, we still view a rate hike is imminent (most likely in December since October isn’t a press conference month) and will probably rise at a snail’s pace unless inflation shoots up faster than expected. Remember, it is not the hike that will kill the market, it is the pace. Organization for Economic Co-operation and Development (OECD) Chief Economist Catherine Mann said the “the path matters four times as much as the timing”.
With the Fed delaying an interest rate hike there are winners and losers in the short term:
Corporate America is on a stock buyback spree that could set a new record. As of the end of August, the S&P had $598.5-billion authorized in share buybacks. At this pace, companies could top the 2007 record of $863-billion authorized amount. Cheap debt is plentiful and management teams have every incentive to play this game of financial engineering. For starters, it makes sense given that a blue chip company can pay sub-2.5% for 5-year debt and save the 3.5% it would pay on its dividend. Companies could also do this to boost their earnings-per-share which might make their companies look better than the top-line really indicates. Management has a vested interest in trying to boost the share price as pay and bonuses tend to be tied to share price performance.
Stockholders of companies that a pursue growth-by-acquisition strategy could feel some pain with global markets and interest rate uncertainty. Rates staying lower for the next few months should be conducive for more M&A as companies struggle to grow their topline in a slowing global economy. There has already been $3.2-trillion in global mergers this year—on pace to match 2007 record.
What has been truly remarkable about this M&A cycle is that since 2011, on average, both the acquirer and the target companies’ share prices have both risen the day of the announcement. This is not normal; historically the target’s share price would go up while the acquirer’s share price would go down. We are starting to see this trend move back to normalization.
In the third quarter of this year, despite it setting a new third quarter record in terms of deal-size being consummated, investors have not been rewarding acquirers as market uncertainty weighs on their minds, as well as having a skeptical view of managements pursuit of growth at any price. In the third quarter, the average decline of the acquirer was 0.6% on the announcement of the acquisition. Some have fared much worse, after Dialog Semiconductor announced the purchases of rival chipmaker Atmel Corp, the stock lost 19% in one day…buyer beware!
This is typically what happens when rates stay low for too long; access to capital becomes cheap, acquirers’ currency (high stock price/valuation) provides management confidence to pay more for growth in a competitive bidding market (sometimes the winner of a take-over is really the loser because they paid more just to win) and shareholders take on execution risk and increased balance sheet leverage.
Some of the worst deals in history were done near the peak of the M&A cycle. Pharma & TMT sectors have been the hottest sectors this year, sounds very similar to the M&A bonaza in late 90s.
Banks and asset managers took it on the chin after the announcement as net interest margin expansion will be delayed for the banks (net interest margins have compressed more than 27% since 2010) and the significant amount of assets still sitting in money market funds. The banks and asset managers are basically managing these funds pro-bono as they’ve been waiving fees over the last 6 years in order to offer a positive yield which is currently averaging 0.01% or $1/year on $10,000. In fact, since 2009, the waivers cost the industry $30-billion in lost revenue.
The game of chasing yield is becoming more dangerous. The global bond market has been expanding rapidly since the financial crisis. The size of the U.S. bond market is now ~$39.5T, almost twice the size of the five largest foreign stock exchanges (in Japan, China and Europe) combined, according to the World Federation of Exchanges.
The combination of low yields, less liquidity (post-financial crisis regulations creating limited dealer inventory), proliferation of ETFs/credit funds, and the expected rise in interest rates, will wreak havoc on bond values when the herd heads for the exits. The 10-year German Bund is a recent example of the perils of a low yield environment. Remember back in mid-April, when the 10-year Bund was trading at an all-time low of 0.05%, within weeks it shot up to 0.786% without any major trigger and caused massive losses for investors.
Here is another example of this crazy low yield environment. On September 22nd auctions at the U.S. Treasury saw huge demand as the Treasury department had been cutting back the supply of T-Bills because the government was nearing the debt ceiling (which will be raised again in a few months). This has had the effect of driving down short-term yields even lower. In fact, the yield on the 4-week Treasury bill was -0.02%! Would you buy this bond?
The third and final print on second quarter GDP came in much stronger than expected at 3.9% annualized versus 3.7%. Consumer and business spending were revised higher, 31bps & 12bps respectively, while inventory accumulation was less than expected. However, there was still some weakness in the export-oriented factory sector being weighed down by the strong dollar. Overall, we were happy to see the positive revisions and their impact on corporation profitability which was also revised up to 3.5% from 2.4%.
The health of both the domestic manufacturing and service sector are in expansion territory but showing signs of weakness. In September, the Institute for Supply Management (ISM) report indicated a decline to 50.2 from 51.1 in August. The report cited weak orders and production, and a steep drop-off in backlogs. The export-oriented manufacturing component has been trending lower of the past year and is now at a 2 year low. We may be seeing a sub-50 reading in the next few reports if weakness persists.
August’s ISM for non-manufacturing report came in at 59 which is still well into expansionary territory (above 50 level) and is nearing a 10 year high. The August industrial production and capacity utilization figures (-0.4% & 77.6% respectively) corroborated the manufacturing slowdown story.
The Industrial Production Report highlighted motor vehicle production dropping 6.4% from a strong prior month. We can take some comfort in the fact that manufacturing only accounts for 12% of GDP. All other economic signs (housing, retail sales, etc.) point to a 2.5% GDP growth in the second half of the year.
September’s non-farm payrolls (NFP) came in worse than expected, 142k versus 201k. August numbers were also revised downward to 136k from the previously reported 173k (expectations in August were 217k). There has been a noticeable deceleration of job growth this year versus 2014. Year-to-date the monthly average NFP has been 198,000 jobs, weaker than both the 12-month and 2014 full-year average, 229,000 & 260,000 respectively.
Within the Bureau of Labor Statistics (BLS) report, there was an increase in private employment over the previous month (118,000 versus 100,000) with most of the hiring in the hospitality, education and retail sectors. Job declines were not surprisingly felt in the manufacturing and mining sectors.
Despite the poor payroll numbers, the unemployment rate remained at 5.1%, the lowest since 2008, thanks to the drop in the participation rate dropping to 62.4% from 62.6%; this was the lowest since October 1977. Overall, the labour market in the U.S. has been improving with the unemployment rate now very close to the Fed’s long-run equilibrium rate, 4.9%.
We are noticing that employment agencies for retailers and logistics companies are having a tough time finding enough warehouse workers for their customers’ demands. As a result there is fierce competition within these companies and you are starting to see this with rising wages and increasing benefits.
Hiring for seasonal workers is starting earlier and companies are starting to announce their hiring plans. UPS mentioned in their earnings call in mid-September that they plan on hiring as many as 95,000 employees this year; other companies, such as Fedex and some retailers (Walmart, Amazon, Target, etc.), plan on hiring in droves. That being said, wage growth in September is still only 2.2%, but if the historical relationship between unemployment and wage growth holds, wage growth should be ~3.5%, and we can expect wage growth to pick up.
August headline Consumer Price Index (CPI) came in at 0.2% year-over-year (CPI ex-food and energy was 1.8% year-over-year). The Fed’s inflation goal of 2% might be hard to reach in the near term given the effects of a stronger U.S. dollar, falling commodity prices and weakness overseas. Import prices dropped 11.4% from a year ago.
While inflation is currently low in the U.S., it is surging in other countries (e.g. Brazil 9.53%, Russia 15.8%, etc.) where currencies have weakened materially. The Personal Consumption Expenditure Index (the Fed’s preferred inflation gauge) came in at 1.3% year-over-year; this is the 40th consecutive month that the Fed’s failed to reach it 2% target.
The U.S. should start to see their inflation numbers inch up close to 2% next year as we lap last year’s big drop in oil prices and strength in the U.S. dollar while seeing further tightening in the labor market; hence, wage pressure. We are still concerned that market participants may be underestimating future inflation and the ramifications this may have on the Fed’s tightening policy.
Volatile markets in late August and choppiness throughout most of September has had an impact on consumer sentiment with the University of Michigan Sentiment Index falling to 87.2 from 91.9. This level is still consistent with real consumption growth of about 3% annualized. We would expect sentiment to improve as markets stabilize and with gasoline prices falling again.
The U.S. consumer is looking healthier in terms of their balance sheet and income growth.
U.S. household wealth set a record in Q2 rising $695M to $85.7T. This can be attributed to a general increase in real estate values as the stock market was essentially flat. In terms of household debt-to-income ratio, it was at 107.4% as of Q2 which is well below the peak of 135%. On the income side, we are seeing a continued improvement in personal income (+0.3% in August) and since inflation is at rock-bottom levels, we’ve seen real disposable income set a record for two consecutive months.
Despite volatile markets and sluggish global growth, the U.S. consumer is still spending. August U.S. retail sales figures came in lower than expected (0.2% vs. 0.3%); however, if you remove the effects of gasoline station sales, autos, and building materials, the number came in at a solid 0.4% month-over-month increase. On a year-over-year basis, retail sales were up 2.2%. July’s retail sales were revised higher from 0.3% to 0.6%.
In September, U.S. auto sales came in at a seasonally-adjusted annualize rate of 18-million units (10% year-over-year) which is the strongest month in over 10 years! SUVs, crossover utility vehicles, and trucks were the drivers of the high sales figure which is not too much of a surprise given low oil prices, lower unemployment, low interest rates, and easy access to credit.
Overall, it’s nice to see the consumer spending again, but we are still concerned about the level and quality of auto credit. Here are a few bullet points that illustrate why we are cautious:
- Auto debt rose above $1-trillion for the first time in Q2. Cars are the 2nd largest purchase that people finance after homes and, just like the housing boom times of the mid-2000s, credit standards have been easing.
- Only 3.3% of car applications rejected by lenders this year compared to 10.3% in 2013.
- Loans are also being extended. In August, the average term of a car loan was 68.2 months which is about 6 months long than 10 years ago.
- The size of a loan has grown 15% over the last 5 years to $29,184 according to Edmunds.
- Loans to subprime borrowers make up ~20% of auto loan balances according to Experian Automotive; the $176-billion of subprime auto loans over double the 2010 balance.
What is happening with all these loans? Well the smart people on Wall Street are doing their same tricks they did with subprime mortgage loans and selling these securitized products to investors. Approximately $21-billion out of the $70-billion in securities backed by auto loans were considered subprime; this is more than double the amount issued in 2010. How much are investors being compensated? Not much, the AAA-rated tranches can fetch a yield of 50bps over equivalent treasuries terms and lower-rated tranches can add another 200bps.
The National Association for Home Builders Index (NAHB) increased from 61 in August to 62 in September. This latest figure was a tick above expectations and showed homebuilder sentiment reach a post-recession high; it’s at the highest level since October 2005.
August housing starts off $1.126-million, down slightly from July (3%), but well ahead of August 2014’s $966,000. Building permits for August, which is a precursor for future housing starts was up $1.170-million, +3.5% month-over-month and +12.5% year-over-year.
The proportion of single-family homes (as a % of total housing starts) was 66%, flat month-over-month. Recall that single-family home construction consumes approximately 3 times more building products than a multi-family home which is beneficial for some of the names in our Canadian and U.S. Equity portfolios that have a housing theme component within them.
Existing home sales fell 4.8% in August to $5.31-million annual rate. This is the first decline after posting 3 consecutive months of increases. This biggest decline came from the single-family segment which declined 5.3% versus a smaller decline in the condo/co-op segment (-1.6%). The inventory levels increased slightly from a 4.9 months’ supply to 5.2 months; however, this is still much lower than a 5.6 month supply a year ago
New home sales for August reached a 7 year high as sales jumped 7% to an annualized rate of 552,000; this number beat all 75 economists surveyed by Bloomberg. The combination of dwindling supply of previously owned homes, low mortgage rates, and steady job gains continue to drive new sales. Another unexpected surprise was the proportion of first-time home buyers, this cohort rose to 32% from 28%!
House prices continue to rise. The S&P/Case-Shiller Home Price Index rose ~5% in July over the previous year; these gains were mostly seen in the west. In terms of housing affordability, prices for houses on the lower end of the spectrum have been increasing at a faster pace than luxury homes. This is a concern to some economists are worried that it might become difficult for younger buyers to afford a home.
The U.S. is still a renter’s nation after the housing bust as the chart below shows that the U.S. homeownership rates (63.4%) is lowest since the mid-1960s.
At the 11th hour, Congress passed a spending bill in order to avoid a U.S. government shutdown; the short-term bill would finance government to December 11th.
The debt ceiling debacle is back. In March, the debt ceiling hit of $18.1T, but the Treasury was able to use some accounting maneuvers to avoid default but will run out of room sometime in November. Remember the debt ceiling debate back in August 2011 when Standard and Poor’s downgraded the U.S. from it AAA rating to AA+ (1st downgrade in 70 years) and the ensuing market turmoil?
Fitch ratings mentioned in late September that there could be “immediate potential rating consequences” should the government head for another debt ceiling standoff. Hopefully the politicians don’t shut down the government for 16 days like they did in 2013. People are wondering if the outgoing house speaker, John Boehner, is able to work out an agreement to raise the debt ceiling before he leaves Congress on October 30th.
THE CANADIAN ECONOMYFinally, some good news for the world’s 11th largest economy! We appear to be leaving behind our technical recession. Canada recorded back-to-back monthly gains in GDP after contracting the first 5 months of the year. In July, GDP grew more than forecasted in July coming in at 0.3% versus expectations of a 0.2% increase. The Stats Canada report showed substantial improvements in categories such as mining, oil & gas finance, insurance and manufacturing. Manufacturers in particular are starting to gain some traction with exports as the Canadian dollar fell to an 11 year low— the U.S. buys ~75% of our exports.
A recent Bloomberg economist survey showed expectations for third quarter GDP growth at a 2.1% annualized pace which is much higher than the Bank of Canada’s 1.5% forecast.
Canada headline employment numbers looked good coming in at 12,100 jobs being added during the month of September versus the expectation of 10,000; this is the third consecutive monthly gain. However, looking below the headline number, the composition of new jobs were not pretty as there were 74,000 part-time jobs added while 61,900 full-time jobs were lost.
Self-employment also rose which is sometimes the alternative to unemployment. On a positive note, Western Canada showed net job growth (i.e. construction +6,900 jobs) despite job cuts in the energy sector (-2,600 jobs). In terms of the unemployment rate, it ticked up slightly from 7% to 7.1% as 30,600 more people entered the labor force.
We don’t expect an interest rate cut when the Bank of Canada (BOC) meets on October 21st, but will be listening to their language around their outlook for the Canadian economy.
Headline inflation in August rose 0.2% month-over-month and 1.3% year-over-year. The increase was driven by food (meat was up 6.3%), shelter, and clothing with lower fuel prices as an offset. The Bank of Canada looks at core inflation which came in at 2.1%, right in the middle of their 1-3% range. Inflation is not too much of a concern for us nor the BOC (keeping rates on hold at their September 9th meeting); the BOC believes that the drop in the Canadian dollar has been boosting the inflation numbers but considers this a “transitory effect”.
Canadian consumer confidence surged to the highest in 2 months according to the most recent Bloomberg Nanos Confidence survey. This survey is conducted weekly by polling 1,000 Canadians asking their views on their personal finances, job security, outlook for the economy, and real estate. The most recent survey highlighted expected strength in the economy and real estate price increases. The one data point that is stuck in neutral is job security; it still remains at very low levels. In terms of regions of confidence, Western Canadians recorded the biggest gains in confidence with B.C. leading the pack…it’s hard not to when real estate prices keep going up!
July’s retail sales increased 0.5% which was lower than consensus estimates, but still up for a third month. The spending increase was driven by light truck sales (6th consecutive gain), but if you exclude the auto sector, retail sales were flat in the month. Consumer spending is holding up (except in Alberta and Newfoundland) as job gains, cheap fuel, and low interest rates continue to promote confidence and spending.
One area of concern is Canada’s household debt. In August, household debt rose at the fastest year-over-year pace in nearly three years, as Canadians continued to pile into residential mortgages due to ultra-low rates.
HousingSeptember month-over-month housing starts rose 7.7% (3-year high) and was much higher than expected (230,700 versus 202,000) driven by urban single-family (0.8%), multi-family (10.5%), and rural housing (7%). Vancouver’s red hot real estate market realized a 10.7% jump in multi-unit projects.
We may see a moderation in housing starts as building permits fell for the 1st time in 3 months (-3.7% month-over-month) during August. Vancouver’s multi-unit housing permits dropped 45.6% to $343-million; however, the city’s total value of permits is still 52.3% higher than a year earlier.
August’s existing home sales were up 4% year-over-year with inventory of unsold homes at 5.6 months (3 year low). Low supply and low interest rates have been putting pressure on housing prices; particularly in Vancouver and Toronto where prices were up 12.2% & 10.3% respectively, according to the Canadian Real Estate Association (CREA). Teranet/National Bank Home Price Index shows a similar story with Vancouver rising 9.7% and Toronto +8.7% in August. Nationally, the price of housing has increased 5.4% year-over-year.
When will this madness stop? Who knows, but it’s clear, Vancouver and Toronto are exhibiting bubble-like behavior where prices are completely detached from incomes and rents.
What did you think of September’s economic activity? Let us know in the comments below!This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of 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.