Highlights This Month
- The impact of tapering and Syria.
- What is happening to the U.S. recovery?
- China’s economic growth continues to slow.
- Can the 2020 Olympics help Japan’s stimulus efforts?
- Europe’s fortunes appear to be turning around.
- The long road to reducing American debt.
- Is encouraging U.S. manufacturing a sign of things to come?
- U.S. housing continues to buoy the economy.
- Why is Canada’s economic growth decelerating?
- The Canadian housing market appears to be just fine.
NWM Asset Class Highlights
It was mainly a risk off month in August. Canadian equities managed to stay in the black, but U.S. equities sold off, as did government bonds.
Fixed income products struggled to stay in positive territory as yields continued their march higher in August. Two-year Canada yields increased from 1.15% at the end of July to 1.20% at the end of August. 10-year Canada’s backed up even more, with rates at the end of August hitting 2.61% versus 2.45% at the beginning of the month.
NWM Bond was flat for the month, a great result given the increase in yields. Eastcoast, Merrit, and RP, were all in positive territory and delivering as expected in a higher interest rate environment.
Positive credit spreads also helped high yield bond returns in August, with NWM High Yield Bond increasing 0.7%.
Global bonds were also higher, with NWM Global Bond increasing 0.2%. A 2.5% decline in the Canadian dollar certainly helped, however; given the decline in emerging market assets, this is still a very good result.
Mortgages continue to provide consistently positive returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.3% and 0.7% respectively. 12 month trailing distribution yields are 4.4% for the Primary pool and 6.9% for the Balanced.
Preferred shares were weak again in August with the iShares Preferred Index ETF down 1.0%. The preferred share market sold off in August and with most traders on summer vacation there were no buyers to support the selling.
Prices dipped mid-month before recovering and ending the month -0.96% with rate resets down -1.22%. NWM Preferred Share continues to outperform and returned -0.9% for the month.
We are constructive on the market at these levels and have purchased several Bank perpetuals that are trading below par to help participate in any broad market rebound.
Canadian equities were stronger in August with the S&P/TSX gaining 1.5% (total return, including dividends), while NWM Strategic Income was down 0.3% and NWM Canadian Tactical High Income was down 0.1%.
Foreign equities were weaker in August with NWM Global Equity down -0.6% versus +0.2% for the MSCI All World Index and -0.6% for the S&P 500 (all in CAD). NWM U.S. Tactical High Income returned -2.5% in USD (about a 0.1% return when converted into CAD).
The REIT market continued to come under pressure in August with NWM Real Estate down 3.0%.
The alternative strategy pools were positive in August. Gold continued to rally with bullion increasing almost 8% in Canadian dollar terms. Gold stocks were up even more, with NWM Precious Metals gaining 12.5% due to unrest in Syria. NWM Alternative Strategies increased 1.3%.
AUGUST IN REVIEW
Equity markets were generally weaker in August, with the S&P 500, Dow Jones Industrial Average and MSCI All World Index down 2.9%, 4.1% and 1.1% respectively in U.S. dollar terms.
What hurt U.S. and global bourses during the month, helped Canadian markets, however, as higher gold and bank stocks drove the S&P/TSX up 1.5%.
Uncertainty in the Middle East (add Egypt to the list) was good for bullion prices and the prospect of higher interest rates, in combination with a stabilizing Canadian housing market, increased the allure of Canadian banks.
A weaker Canadian dollar also made U.S. and foreign equities more attractive, with the MSCI declining only 0.2% in Canadian dollar terms while the S&P 500 lost only 0.6% for Canadian investors.
Though it is always hard to predict geo-political events and we could be proven wrong by the time you read this letter, it is looking increasingly less likely the U.S will intervene in Syria.
A Russian brokered deal that would see Syria give up their chemical weapons is possible and could permanently forestall strikes.
We suspect this is just a stalling tactic by Putin and Assad, but it works for Obama, too, as public opinion had started to swing against air strikes and Obama’s decision to attain approval from Congress before taking action was likely to end in failure.
Congress failing to reach a consensus? Shocker.
If the U.S. does not take action against Syria, markets could rally while oil and gold could reverse recent gains.
Also helping improve investor sentiment near the end of the month and early September was the increasing belief that, while the Federal Reserve will begin tightening monetary policy in September, it will be done slowly, a sort of “taper lite” if you will.
Perhaps the Federal Reserve will only buy $70-billion a month in mortgages and treasuries versus $85-billion and assure investors an increase in the Federal Fund Rate is a long way off.
The economy in the U.S. is recovering, but at a marginally slower pace than a few months ago. Corporate earnings growth has also slowed, with second quarter earnings for the S&P 500 up only 2.2%, the second lowest increase since the financial crisis.
With sales expected to grow a meager 0.8% and profit margins stretched, earnings estimates are likely to continue to move lower. In this environment, the last thing the market needs is a tighter monetary policy.
Oh, and did we mention September is historically a bad month for the markets?
While U.S. markets may have been held back by the prospect of Federal Reserve tapering, it was the emerging markets that took a bigger hit.
Not only are emerging market economies like India, Indonesia and Brazil being hurt by slow global economic growth, they also typically run current account deficits and require a continuous inflow of foreign capital to keep their economies expanding.
The fear is that a lot of this foreign capital was coming straight from Federal Reserve’s printing press and “tapering” could result in a sudden disappearance of Yankee cash.
Investors appeared to be selling in anticipation of a potential cash crunch and currencies like the Indian rupee, have been plummeting. Hopes the emerging markets would take over as the engine of growth for the global economy may have been a bit premature.
As mentioned last month, economic growth in China is slowing. The difference between China and a country like India, however, is that China has run current account surpluses for years, and as a result, doesn’t need to rely on foreign capital to finance its growth.
That doesn’t mean China doesn’t have a debt problem, however, it’s just that they keep their problems in the family.
According to the Bank for International Settlements, household and business debt in China rose to 170% of GDP in 2012 versus only 117% in 2008. At current interest rates, principal and interest payments on this debt consumes about a third of China’s GDP.
By comparison, pre-financial crisis debt-to-GDP in the U.S. reached 177% and the equivalent debt service ratio was only 21%.
While it is easy to conclude the rapid increase in debt in China will result in a U.S.-style debt crisis, one needs to consider that while the absolute level of debt maybe similar, the composition of debt is not.
The U.S. credit boom was comprised of mostly mortgage debt while most speculative Chinese home buying is financed with cash. Local government and state-run companies are the big borrowers in China and it is unlikely the central government will let them default.
In fact, the Chinese bond market, which is dominated by local government and state-run company issuers, has never experienced a default. But just because you never default, doesn’t mean non-productive loans can’t hurt your economy.
Banks loaded with “zombie” loans can quickly find they don’t have sufficient capital to make new loans, thus slowing economic growth. For this reason, some analysts are suggesting a potential Chinese debt crisis would look more like Japan’s lost two decades than the U.S. financial crisis.
Neither is particularly attractive.
But these are all concerns for the future. China’s immediate goal is to re-invigorate a slowing economy, and looking at the data released in August, it appears they are on the right track.
Exports rose 7.2% in August versus +5.1% in July and a contraction of 3.1% in June. Industrial production rose 10.4%, and at 50.1, HSBC’s manufacturing PMI index moved back into expansionary territory.
The gains, however, were mainly from heavy industry, which tend to be dominated by state-led companies and funded by capital investment. For economic growth to be sustainable in the long term, China needs to rely less on investment and more on consumer spending.
With retail sales in August increasing 13.4% versus 13.2% in July, growth in consumer spending showed more modest gains.
Don’t get us wrong, August proved to be a good news month for China — the Chinese stock market and those of emerging markets reacted favorably near the end of the month. It just doesn’t look sustainable.
China wasn’t the only economy to deliver good news last month. Second quarter GDP growth in Japan was revised up to 3.8%, which, in combination with first quarter growth of 4.1%, translates into the strongest 6-month economic growth for Japan in three years.
In addition, industrial production increased 3.2% in July, reversing the 3.1% decline in June. Even inflation is starting to accelerate, with CPI in July increasing 0.7%, the largest annual gain in more than four years. At 3.8%, unemployment in July came in at its lowest level since October 2008.
To top it all off, Tokyo was awarded the 2020 Summer Olympics. The hope is that hosting the games will add to the economic stimulus being provided by “Abenomics” and some are even referring to it as Prime Minister Abe’s fourth arrow (Abenomics is described as three economic policy arrows).
Stronger economic growth and increased confidence will also give Abe the room to push forward with a planned doubling of the national sales tax to 10% by 2015.
The tax increase is seen by many economists as vital to reigning in government debt levels, which currently are on an unsustainable trajectory and surged past ¥1-quadrillion (approximately $10-trillion USD) in June.
To be frank, even this might not be enough. Abe might want to keep one more arrow for himself, just in case.
With the purchasing managers index for the Euro-zone remaining solidly in expansion territory in August, it is likely GDP growth continued during the summer months.
Europe’s biggest economies continued to lead by example, with Germany posting GDP growth of 0.7% and France +0.5%. Germany’s PMI index, in fact, hit a seven month high of 53.4 and industrial production in June increased 2.5% versus the previous month.
While this is good news and reinforces the view the Euro-zone has emerged from recession, the growth is still modest and not yet strong enough to drive the unemployment rate lower.
While Germany may be leading the Euro-zone out of recession, the periphery is slowly starting to turn the corner as well.
Portugal actually grew 1.1% in Q2. And while Italy, Spain, and Greece still contracted, it was at a much slower pace.
Helping increase economic growth is tourism. Even though Southern European countries are not able depreciate their currency in order to become more attractive to foreign vacationers, declining wages are producing the same effect.
Greece, for example, enacted changes to their labour laws that helped push wages down 20%. Given payrolls comprise about 40% of a hotel’s operating costs, this enabled room rates to fall an average of 8% over the past year.
In addition, demand is up as tour operators avoid the beaches of crisis stricken North Africa. For investors, emerging Europe (countries such as Poland, Bulgaria, Hungary, and the Czech Republic) is also getting more attention as an alternative to traditional emerging market favorites such as Brazil, Indonesia and India.
If Europe is recovering, then manufacturing-oriented Eastern Europe is well positioned to take advantage.
A recovery in Europe is far from a given, however. Private-sector debt levels remain high as the Euro-zone hasn’t experienced the same level of mortgage debt default as experienced in the U.S.
U.S. banks have largely purged their balance sheets of non-performing loans and are in a position to start lending again.
Not so in Europe, and tighter rules on capital and leverage could crimp lending even more with the Royal Bank of Scotland estimating Euro-zone banks may need to shrink their balance sheets by €3-trillion over the next three to five years.
Fortunately, the two largest economies in the Euro-zone (Germany and France) have relatively low private sector debt levels, perhaps explaining why these two economies are growing while most of the Euro-zone is not.
The good news is the Euro-zone is starting to make progress on reducing government debt, with Greece recently reporting a primary (before interest payments) budget surplus for the first seven months of the year.
It has comes at a cost, though, with Greek GDP contracting 4.2% in Q2 and the unemployment rate hitting 27.6% in May.
According to the Treasury Department, revenues are running 14% ahead of last year while spending is down 3%. Based on current trends, it is estimated the U.S. could close out the year (fiscal year end September 30) with a deficit to GDP of around 4%.
Not bad compared to the more than 8% hit during the financial crisis, but still elevated compared to historical norms. Of course the real problems begin in about ten years when demographics start to work against the U.S. and social security and Medicare costs really take off.
Even before this happens, the math starts to get a little tricky.
With interest rates at rock bottom levels, 6% of federal spending is currently being spent servicing the federal deficit. The White House estimates interest costs will consume 14% of federal spending by 2023. And this is the White House estimate!
You have to believe they are less than objective or conservative. With 40% of U.S. debt coming due in the next couple of years, an increase in interest rates of a couple of percent could increase the deficit by over $130-billion.
So what do you do? Republicans want to reduce spending and plan to use the upcoming debt ceiling debate as a bargaining chip. Ultimately, the ceiling will be raised, but it could come right down to the wire, which is estimated to be by mid-October.
The Federal Reserve wants to start begin “tapering” down their $85-billion a month purchase of treasuries and mortgages. Good for them. It needs to be done. The Fed is sitting on about $2-trillion in securities they are going to eventually have to sell and the sooner they get started the better.
With the Congressional Budget Office estimating a 2014 deficit of $560-billion and the Feds presently buying $540-billion in treasuries ($45-billion a month), the Federal Reserve is effectively taking down all new federal government debt issuance. Surely that’s not right.
The problem is the market has gotten hooked on cheap money and any signs of tightening will have investors dumping bonds, thus driving interest rates higher. This is bad for the sputtering economy, and also bad for the deficit.
So yes, we see some economic recovery in the U.S. as well as Japan, China, and Europe. Our concern, however, is that it is driven by credit growth that could soon be coming to an end.
The emerging markets maybe the preverbal canary in the coal mine in showing the capital markets what is going to happen when the tap is turned off.
Fortunately for the markets, central banks are not good at turning off the tap.
The U.S. Economy
So far, the U.S. economy has managed to shrug off tax increases and government spending cuts implemented earlier in the year as second quarter GDP growth was revised up to 2.5%.
Driving GDP growth higher was business investment, increasing 9.9%. Stronger purchasing manager indexes also indicate the manufacturing sector remains strong, and while housing was revised down to +12.9%, it remains a source of strength for the U.S. economy.
Only durable good sales were weak, and this was mainly attributed to lumpy aerospace deliveries.
The U.S. has being shedding manufacturing jobs for years. While presently employing 12 million workers, twenty years ago almost 17 million American workers earned a living in the manufacturing sector.
In 2000, 19% of the world’s manufacturing exports came from U.S. factories versus only 11% in 2011. Now, thanks to cheap natural gas and less restrictive labour laws, the U.S. has a cost advantage over many of their global competitors.
This is especially true compared to most European competitors, but the Boston Consulting Group believes the cost gap between China and the U.S. will shrink to a mere 10% by 2015. The result could translate into more jobs and a declining trade deficit.
It’s a slow process, however. Most analysts expect GDP to grow moderately at best in the short term. Will this be enough to compel the Federal Reserve to raise interest rates? Unlikely. Will it be enough for the Fed’s to start “tapering?” Probably, though the question is how much.
The betting is the Federal Reserve announces a reduction in their tapering program at their September meeting. If it’s more than $15-billion, the market is likely to be disappointed and sell off. Most feel $10-billion would be a good start.
Another disappointing month for the job market in August. Not only did job growth last month fail to meet expectations, but June and July’s gains were revised 74,000 jobs lower.
The unemployment rate moved slightly lower to 7.3%, but mainly due to a decline of over 300,000 in the labour force.
On the positive side, jobless claims fell to their lowest level since October 2007 and wage growth accelerated slightly. Even so, U.S. wages have struggled to keep up with inflation over the past three years, even with inflation at historically low levels.
As mentioned above, inflation is not an issue.
A split decision in August as the University of Michigan consumer confidence index was down while the Conference Board consumer confidence moved higher. This is the reverse of last month so we don’t read much into this.
Overall, consumer confidence has been rising due to the rebound in housing and the stock market, as well as a more robust job market. Perhaps the best indicator of improved consumer sentiment can be found in the fertility rate.
After falling over the past four years, the fertility rate in the U.S. for women 15 to 44 stabilized last year at 63.2 births per 1000 women.
With increased confidence comes increased spending, and the U.S. consumer loves to spend. After several years of restraint and deleveraging, Americans are spending again, but they are more being selective.
Auto sales have been soaring as consumers begin to replace an aging auto fleet. Trucks are in particular demand given increased activity in the housing and oil and gas industry. Clothes and general merchandise, not so much.
Apparently this year’s back to school merchandise lacked a discernible fashion trend and isn’t attracting much demand. As a result, consumers could see some nice sales come September and early October as retailers make room for Christmas inventory.
Yes, Christmas is just around the corner.
The housing market continues to provide support to the U.S. economy. Pending sales in July fell slightly, indicating we could see softer existing home sales over the next several months, but overall, the market appears healthy.
Higher interest rates remain the potential fly in the ointment, however, as increased mortgages rates reduces affordability. We don’t see the current move in interest rates adversely impacting the housing market yet, but if rates continue to march higher, the housing market could come under pressure.
The U.S. trade deficit widened in July as imports increased 1.6% while exports declined 0.6%. The increase in imports is a positive indicator of U.S. consumer strength and should bode well for economic growth in the second half of the year.
If China, Japan and Europe continue to recover, export growth should follow.
Overall, the U.S. economy slowed, but not enough to prevent the Fed from tapering. Look for a “tempering lite” solution and a commitment to keep rates low. If the consumer starts to pull back, all bets are off.
The Canadian Economy
More concerning, however, was a 1.9% drop in manufacturing, which shouldn’t have been impacted by either of these issues. Interestingly, both the RBC and Ivey Purchasing Manager’s Indices moved higher.
Consumer spending continues to support growth, increasing 3.8% in Q2, with strong auto sales leading the way.
A great rebound month for the Canadian job market as the previous two-month losing streak was offset with nearly 60,000 new jobs. Most, however, were part time, (42,000), and skewed to older age categories. Also, wage growth slowed to its slowest pace since late 2011.
Gasoline prices were up 6.1% year-over-year in July, but food inflation was only 0.8%. In particular, sugars, fats and oils deflated 1.2%. It’s a good time to have a sweet tooth in Canada!
Retail sales declined in June, though the Quebec construction strike and Alberta floods accounted for much of the decline. Strangely, Ontario retail sales also declined while most other Provinces experienced an increase in sales.
What the heck is going on in Ontario? They appear to be in a funk, and the Leafs haven’t even started playing yet!
Overall, Canadians appear to heeding the advice of the Bank of Canada and saving more, but debt levels remain high. Interestingly, average consumer debt in Q2 actually increased 0.7% versus Q1 and 6.1% versus last year to $27,131.
Driving the increase was an 8.6% increase in auto loans and a 7.4% increase in mortgage debt. It appears fears of higher interest rates are persuading Canadian to borrow now before rates move higher.
The Canadian housing market continues to be just fine, thank you. Housing starts moved lower in August, but some moderation from overbuilt levels is probably healthy. Besides, permits were up over 20%.
Existing home sales remain positive and the inventory of homes for sale is a healthy 6 months. Sales in Vancouver continue to rebound, as do prices. While on a year-over-year basis, Vancouver home prices have fallen for 12 consecutive months, month-over-month prices increased 0.3% in July.
As a reminder of how expensive Canadian house prices remain on a relative basis, the Economist recently updated their global comparison which indicates Canada is 74% overvalued based on rents and 30% overvalued based on disposable income per person.
A tough global economy is hurting exports. A strong U.S. economy should help Canada’s balance of trade move positive in the coming months.
We are a little nervous that the slowdown in Ontario retail sales and manufacturing activity could translate into slower economic growth in Canada. It is the center of the universe after all.
Also, while we are encouraged with the soft landing in the housing market, we are not yet convinced that a more severe correction has been avoided and the prospect of higher interest rates isn’t giving the market a short term boost.
Not saying this is the case, just a little wary.
What did you think of June’s market 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 fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.