Highlights This Month
- How close is “The Great Rotation”?
- The gradual shift to stock investing.
- Debt continues to soar in Europe.
- Is the outlook brightening for China?
- U.S. companies deal with The Fiscal Cliff.
- 2012 a turn-around year for real estate in America?
- Canadian GDP growth exceeds expectations.
- Housing sales in Canada on a downward trajectory?
The NWM Portfolio
It was a risk on month in January.
All things considered, bonds did pretty well with the NWM Bond Fund up 0.2%. Short rates backed up slightly with 2-year Canada’s going from 1.14% at the end of December to 1.16% at the end of January. Ten year Canada’s fared worse, with yields increasing from 1.8% to 2.0%.
High yield bonds continue to defy gravity, with the NWM High Yield Bond Fund gaining 1.0% in January. We are a little concerned that credit spreads have narrowed as much and as fast as they have. Most of our managers are positioning into higher quality issues. Expect coupon level returns at best over the near term.
Mortgages returns were strong in January. The NWM Primary Mortgage Fund returned 0.2%, same as December, but the NWM Balanced Mortgage Fund increased 0.9% versus 0.4% last month.
Preferred shares were up in January with the NWM Preferred Share Fund gaining 0.6%. The first of the bank reset become eligible for redemption in April, so we should begin to get some idea of which issues the banks will redeem and how the preferred share marketplace will evolve. At the margin, we have tried to avoid issues that we believe will be redeemed, especially if they are large premiums.
Canadian equities were stronger in January with the S&P/TSX gaining 2.25% (total return, including dividends), while the Strategic Income Fund (SIF) returned 3.5%. A good result given the SIF usually lags in a strong equity market.
Because we presently have a more constructive view of the market, we continue to run the fund a little more aggressively. The cash weighting remains low and we have also been less aggressive in writing call options, with just over 12% covered as of mid-February.
Consequently, the running yield of the portfolio is about 4.2%. We would expect to write some more options in the near term and get the yield up a bit, but we would also like to leave a little more room for capital appreciation than in previous months.
Foreign equities had another strong month in January with all of our external funds posting positive returns during the month. The NWM Global Equity Fund gained 4.7% while the MSCI All World Index was up 5.4%.
Real estate lagged the equity markets with the NWM Real Estate Fund up 0.9%. Still pretty good given returns over the past few year have been so strong. As with high yield bonds, we would expect returns to come mainly from distributions in the near term rather than multiple expansion.
The alternative strategy funds were mixed in January. Gold bullion was down 0.2% in Canadian dollar terms, but gold stocks declined more with the NWM Precious Metals Fund down 3.8% than the NWM Alternative Strategy Fund, which was up 1.2% in December.
JANUARY IN REVIEW
The January Effect was in full swing last month as the S&P 500 and Dow Jones Industrial Average rallied an impressive 5.2% and 5.9% respectively. This is the strongest start to the year for the S&P 500 since 1997. The S&P/TSX trailed with a lower, but still positive, 2.3% return.
The January Effect is a market anomaly whereby stocks rise in January, presumably as investors re-purchase positions sold in December for tax purposes. This is good news for investors as a strong January usually translates into a strong year, especially when returns are over 5%.
Deutsche Bank’s David Bianco recently pointed out that since 1960 there have been nine years in which the market was up over 5% in January. The average return for the S&P 500 during those nine years was 23%.
In fact, the annual gain was over 19% every year, except for one, the market crash of 1987.
Not surprisingly given these returns, investors were busy buying stocks in January, with TrimTabs Research estimating $78-billion flowed into to stock mutual funds and ETF’s, the largest monthly injection since at least 2000.
Investors have been busy pulling money out of stocks since 2008 and despite good returns last year, J.P. Morgan estimates a net $9-billion was redeemed in 2011 and 2012. Could the tide be finally turning in equities favour?
Referred to as “The Great Rotation,” many strategists have been predicting the stampede from equities to bonds could soon reverse.
And why not? With the average dividend of the S&P500 at 2.2% compared with 10-year Treasury yields around 2%, investors see little reason to stay in bonds, especially if the economy looks to be recovering.
We believe “The Great Rotation” will happen, but it is unlikely that we saw it start in January. Money was actually still moving into bond funds in January and the source of the equity buying was more likely from investors draining cash positions.
In addition, special dividends paid by U.S. corporations in December before taxes on dividends increased were also likely a source of cash for equity purchases.
Going forward, investors are likely to allocate more to equities, but we are not sure there will a mass exodus out of bonds.
If investors start dumping bonds, yields would rise, and this has historically been detrimental to stock valuations and economic growth. It’s a bit of a catch 22. The “Great Rotation” will happen, but it will likely be a gradual shift.
Another reason why the shift should be gradual is fundamentals for stock investing are actually not that great. Don’t get us wrong, the economy is brightening, but perhaps not as much as would be indicated by stock market returns in January.
While fourth quarter earnings have been coming in better than expected, corporate earnings estimates for 2013 have in fact been coming down and companies continue to scale back investment.
We also think the U.S. economy could get off to a slow start this year given the increase in the payroll tax and higher tax rate for those earning more than $400,000 per year.
There seems to be a disconnect between investor sentiment and fundamentals. We like the prospects for equities, especially versus bonds, but perhaps the market is a little ahead of itself.
Also weighing on investors is uncertainty regarding the looming $85-billion across-the-board spending cuts set to take effect on March 1.
Neither the Republicans nor the Democrats believe the indiscriminant cuts are good policy, but the Republicans appear firm that any new deal must involve a reduction in spending.
Republican concerns over unsustainable government deficits were partially confirmed by the updated projections from Congressional Budget Office (CBO) which indicate that even with the spending cuts, debt to GDP will hit 77% by 2023.
The CBO estimates an additional $2-trillion in spending cuts over the next 10 years are needed in order to get U.S. government debt back down to historical levels.
Even though the deficit is projected to decline over the next few years (assuming the economy continues to recover), higher healthcare spending will result in the budget deficit resuming its upward trajectory by 2016.
It is estimated healthcare spending currently consumes nearly 25% of all federal spending and the CBO projects this will increase to nearly 33% in 10 years.
Demographics and rising medical costs are the culprits. Medicare has 50 million enrollees presently and it is expected 80 million will be eligible by 2030. Expensive new drugs and an increase in chronic diseases which are costly to treat, add to the cost.
Of course, there are also opportunities to cut costs. It is estimated 20% of health care spending is associated with either over treatment, inefficient coordination among providers and fraud.
Healthcare spending has in fact slowed recently, with national health expenditure increasing only 3.9% in 2009-11, the slowest growth in the 52 years that these statistics have been kept. Most believe this was due to the economy, however, and costs will begin to accelerate again once workers back to work and regain insurance coverage.
Bottom line: the Republicans are right. The U.S. needs to address the unsustainable path of their government debt before the bonds market forces them to do so.
Euro-zone industrial output declined 3.7% in November, the largest decrease since November 2009. With November marking the third month in a row of contracting output, it is almost certain GDP will decline in the fourth quarter for the third straight quarter.
The unemployment rate increased for the 19th month in row to 11.8% with 190 million looking for work. For workers under the age of 25, the unemployment rate hit 24.4%.
Spain continues to suffer more than most, with fourth quarter GDP expected to contract 1.7% and an unemployment rate of 26.6%. For Spanish youths under the age of 25, the unemployment rate is an unfathomable 57%.
Even Germany is feeling the pressure. It is estimated German GDP fell 0.5% in the fourth quarter and grew a mere 0.7% in 2012 versus 3% the previous two years.
For 2013, the German economic ministry estimates GDP will expand only 0.4% before rebounding to 1.6% growth in 2014.
This is pretty anemic – and Germany is the best of the lot. Pretty hard to get your fiscal house in order with numbers like these.
It’s not all doom and gloom for the Euro-zone, however. Economic reforms are being implemented and countries, such as Greece, are becoming more competitive.
Also, the promise by ECB President Mario Draghi to do “whatever it takes” to keep the Euro-zone together has helped stabilize confidence in the Euro and the bond market. 2013 will be a challenging year, however, with Italian elections in February likely the first test.
Other potential flash points include bailouts for Cyprus and Spain (finally applying for OMT [Outright Monetary Transactions] relief) and progress on previously announced plan for a Euro-zone banking union.
We can hardly wait.
Fourth quarter GDP growth accelerated to 7.9% versus 7.4% in the third quarter and the HSBC Manufacturing Purchasing Managers Index rose to 51.9 in January, indicating that manufacturing is expanding.
Even house prices have started climb again, increasing for the second month in a row in January. Of course, this is not good for inflation, which, in combination with the coldest winter in three decades, has peaked government officials’ concerns over rising prices.
The trade-off between economic growth and inflation is always a fine line for China.
Despite considerably lower official estimates, if “hidden” income is included, it is estimated the richest 10% of Chinese households earn 65 times that of the poorest 10%.
China’s official Gini coefficient (measure of inequality named after an Italian statistician) was recently measured at 0.47, almost the same as the U.S. A score of 1 indicates perfect inequality while a score of zero indicates perfect equality.
Texas A&M professor Gan Li estimates the real Gini coefficient is closer to 0.61, comparable to many African and South American countries.
State planners have been trying to get a plan approved to narrow the gap between the rich and poor for the past eight years without success.
New Communist Party Chief and incoming President Xi Jinping has a new plan that would increase taxes for state-owned firms in order to fund welfare programs with the goal of shifting 1-2% of China’s GDP to the household sector by 2015.
While this is a move in the right direction, the magnitude needs to be kept in perspective. China’s goal is to allocate 12% of government expenditures to welfare programs by 2015, yet the U.S. is currently setting aside 36%.
It puts the whole U.S. entitlement spending debate in perspective doesn’t it?
Of course, rather than reduce income inequality, it could be the government’s priority to maintain the status quo. We say this because government officials are a large part of the problem.
Of the 3,000 members of China’s National People’s Congress, 75 appear on the Hurun Report’s 2012 richest 1,024 list (don’t ask me why the list is 1,024 and not an even 1,000) with an average wealth of over $1-billion.
What’s more, of the richest 1,024, those that are also members of the National People’s Congress have seen their incomes grow much faster than those with no national political position.
They came to do good, and have done very well.
If China wants to increase consumer spending, they need to narrow the income gap and drastically enhance the social safety net. Long term, this is the only way the Chinese economy will be able to continue to grow.
The U.S. Economy
Fourth quarter GDP shrank a worse-than-expected 0.1%, the first quarterly contraction for the U.S. economy in more than three years.
Federal government spending fell 15% – the largest decline since 1973 – and included a 22% decrease in defense spending (also largest since 1973).
Many businesses also drew down inventories in the quarter, presumably fearing they would be caught with unwanted product if the fiscal cliff resulted in a recession. Offsetting the weakness was a 13.9% increase in personal spending and healthy gains in residential and business fixed investment.
While the decline in GDP was an unwelcome surprise, healthy contribution to growth from private economy sectors such as housing, business investment and consumer spending, was encouraging.
U.S. companies, in fact, increased spending on equipment and software by 8.4%. Hopefully, this indicates corporate America is finally starting to deploy some of the large cash reserve they have been hoarding.
Additionally, U.S. companies appear to be looking beyond the fiscal cliff debacle. A survey by the National Association for Business Economics found 75% of respondents felt anxiety over the fiscal cliff had no impact on their hiring or capital spending.
The average American is perhaps a little more cynical. A Wall Street Journal/NBC survey of 1,000 adults found consumers “perceive tough times ahead” and the political battles in Washington have taken a toll on their confidence.
It’s just that it hasn’t prevented them from hitting the malls, yet.
For the year, GDP grew 2.2% versus 1.8% in 2011. A survey of 52 economists conducted by the Wall Street Journal has pegged U.S. GDP growth at 2.4% in 2013; the same growth they predicted last year, but they generally see more underlying strength in the economy this time.
Most feel there is a greater chance GDP grows faster than expected and put the odds of “greater than 3% growth” at 24% versus odds of a recession at 17%.
Look for slow start to the year, but a stronger finish.
January was an average month for job growth, but upward revisions to November and December encouraged investors.
January payrolls increased just over 150,000, about what the U.S. needs to keep up with population growth. In order to reduce the ranks of the unemployed, the U.S. needs to create more jobs than this.
December was revised up to 196,000 and November moved to 247,000. Now we’re talking. All the gains came from the private sector and were broadly based.
Unfortunately, the unemployment rate ticked slightly higher to 7.9%, but we wouldn’t read much into this. The unemployment rate may actually remain stubbornly high as workers re-enter the job market as the economy slowly recovers.
This is a good thing, because workers who have been jobless for a long period of time risk having their skills erode and becoming permanently unemployable.
Currently, there are an estimated 4.8 million Americans who have been out of work for six months or more.
The good news: this is 1.7 million less than in 2010 and 830,000 less than only a year ago. Workers unemployed for six months or more actually accounted for nearly the entire 843,000 person drop in total joblessness over the past year.
The bad news: the pay for those finding work is not great. The Institute for Employment Research estimates every year of joblessness reduces a worker’s wages by about 11% when they finally do land a job.
Even worse, the unemployment rate for those out of work for more than three years has barely budged. Many are former construction workers. Hopefully a recovering housing market will bail them out.
Inflation remains well under control, and more importantly, so are inflationary expectations.
Consumer confidence indices gave contradictory signals in January as the University of Michigan consumer sentiment index rose slightly while the Conference Board consumer confidence index fell to its lowest level since November 2011.
The increase in the University of Michigan index was apparently due to increased optimism among higher wage earners, who are not impacted as much by the 2% increase in payroll tax.
December retail sales were lackluster, but January same store sales were stronger than expected as a resolution to the fiscal cliff and enticing discounts put consumers in a buying mood.
That mood might not last, however, as the Tax Policy Center estimates the payroll tax increase could take $900 to $1,000 out of consumer pocket books this year. A RBC survey found 80% of U.S. consumers were aware their paychecks are getting trimmed and nearly 60% plan to spend less.
In addition, the last minute fiscal cliff deal will result in a delay to the tax filing season and result in tax refunds arriving later than normal. This could result in even weaker retail sales earlier in the year.
Consumers are in better shape, however. U.S. households spent only 10.6% of their after-tax income on debt payments in the third quarter last year. If other required payments are included, such as rent and auto lease payments, the total increases to 15.7%.
It’s been nearly 30 years since consumers’ so-called “financial obligations ratio” has been this low. At the peak of the housing bubble, it approached 19%. Low interest rates certainly help, but consumers have also reduced their debt loads over the past five years.
A recent FICO survey found 61% of U.S. bank risk professionals expect to see an increase in requests for credit line increases this year and 59% believe credit card balances will rise. They conclude 2013 could be the year Americans begin to embrace credit again.
Sales increased 9.2% for the year to 4.65 million – the highest since 2007. Even more encouraging, there were only 1.82 million homes for sale at the end of December, the lowest level since January 2001.
At the present pace of sales, it would take a mere 4.4 months to clear the market. The National Association of Realtors estimates a third of purchases in 2010 (the most recent records available) were investment related while Corelogic reports 13.6% of mortgages originated in December 2012 were to buyers purchasing a second home or investment property.
Hedge funds have been very active with John Paulson, who literally made billions betting against the housing market in 2006-7, having bought enough land to build up to 25,000 homes in California, Arizona and Nevada.
Deutsche Bank sees prices increasing another 5-10% in 2013 and believes the housing sector could add up to 2% to GDP growth this year. While we believe the housing market has turned, we are perhaps a little more cautious than Deutsche Bank.
The housing market still has a long way to go and the market is already discounting a strong rebound. We think investors will have to be selective in where they allocate capital.
The trade deficit widened slightly in November with imports up nearly 4%. Apparently iPhone sales were the major reason for the increase and, unfortunately for Apple, this is unlikely to be sustainable.
The Canadian Economy
GDP growth exceeded expectations in November, posting its strongest gain since April. Manufacturing, oil and gas and power generation were all strong. The fourth quarter is still expected to grow an anemic 1% and prospects for the first quarter 2013 are similarly modest.
While oil and gas extraction was strong in November, low oil prices have been a drag on Canada’s economic growth, with the Bank of Canada estimating lower prices shaved 0.4% off GDP growth in the last 6 months of 2012.
Depressed oil prices are also a major reason why the Bank of Canada lowered its 2013 growth rate 0.3% to 2% for 2013.
In addition, the housing market is slowing rapidly and is likely to become a headwind for economic growth in the future. Residential housing presently accounts for about 7% of GDP versus a 50-year average of about 5.8%.
Ben Rabidoux of M Hanson Advisers recently pointed out that the housing related sector, (which includes construction, insurance and real estate services) is estimated to account for 27% of Canadian GDP and has accounted for 44% of GDP growth since 2005.
At the peak of the U.S. housing bubble, the comparable sectors represented only 25% of U.S. GDP. Capital Economics estimates a slowing housing sector could now shrink Canadian GDP by 0.5% in Q1 2013.
Canada’s labour market got off to a poor start in 2013, losing 22,000 jobs. The unemployment rate decreased to 7%, however, as 57,500 workers left the labour force.
While the poor January job report is not good news, it is not surprising given the strong gains over the past couple of months.
As with our comments regarding the impact of a housing slowdown to GDP growth, same goes for the job market. Ben Rabidoux estimates 7% of the Canadian labour force, or 1.3 million workers, are employed in the construction industry in Canada and a U.S.-style bust could result in 370,000 joining the ranks of the unemployed.
Even more disturbing, if these workers follow the lead of their U.S. counterparts, they could remain unemployed for an extended period of time.
Already Canada has more than 250,000 workers who have been out of work for more than 27 weeks, twice the levels just five years ago. The average duration of unemployment at 20.2 weeks is also at its second highest level in 13 years.
Inflation remains a non-issue in Canada. Core inflation is at a 12 year low in Canada.
November retail sales came in slightly better than expected, but October was revised lower. Low interest rates and a strong job market (this month excluded) should keep consumer spending healthy in Canada.
Expect moderation from previous months due to a slowing housing market, but retail sales should continue to expand.
Pricing continues to hold up, but sales remain on a downward trajectory. More worrisome, the construction industry looks to be slowing rapidly with housing starts and permits down sharply.
Canada has averaged around 210,000 housing starts per year over the past decade while demographic demand has been about 180,000-185,000. We over built for a long period of time, so it would not be unexpected to under build for a period of time.
Greater Vancouver remains ground zero with sales in January down 14% from a year ago and 18% from December. Prices are down only 2.8% versus last year, though anecdotally, that seems a little low to us.
So far, sellers don’t seem desperate to sell and are more inclined to take their homes off the market rather than lower prices. If this changes, prices could fall rapidly.
The trade deficit widened in November as imports rose nearly 3% due to higher electronic and electrical equipment volumes (The iPhone 5 Effect?).
Low oil & gas prices and a slowing housing market are major concerns for the Canadian economy.
A stronger U.S. economy could be a good offset, but we need to be able to get our oil & gas exports to market and the degree to which the housing sector contracts in Canada will go a long way to determining our economic fortunes for the coming year.
What did you think of January’s market activity? Let us know in the comments below!