Highlights This Month
- ARE RISING INTEREST RATES AN IMPENDING RISK?
- THE RELATIONSHIP BETWEEN DECLINING EUROPEAN AND U.S. BOND YIELDS.
- ASIA IS SLOWING, BUT WHY IS JAPAN THE ONLY MAJOR MARKET IN NEGATIVE TERRITORY?
- WAGE GROWTH CONTINUES TO LAG IN U.S. RECOVERY.
- CONSUMER CONFIDENCE IS UP – SO WHY AREN’T SALES INCREASING?
- THE U.S. HOUSING MARKET BEGINS ITS MARCH TO A SUSTAINED RECOVERY.
- AUGUST CANADIAN JOB FIGURES DISAPPOINTING.
- CANADIAN HOUSING STARTS DECLINE, BUT STILL TREND POSITIVE.
- WHAT’S THE OUTLOOK ON THE CANADIAN ECONOMY?
The NWM Portfolio
Returns for NWM Core Portfolio were up 0.6% for the month of August. The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships. Actual client returns will vary depending on specific client situations and asset mixes.
Returns were mainly positive in August with both bond and fixed income returns adding value in the month.
Canadian equities were strong again in August with the S&P/TSX gaining 2.1% (total return, including dividends), while NWM Strategic Income was up 2.4% and NWM Canadian Tactical High Income was up 1.2%.
The cash position in the Strategic Income Fund is currently about 3.4% with approximately 6% of our Canadian and 2.0% of our U.S. positions covered. We would expect these percentages to move higher over the next few weeks. Recent trades include new positions in Valero, Delphi, Power Corp and SNC Lavalin and the sale of Empire and IBM.
With Canadian Tactical High Income, we established a position in Pure Multi-Family REIT. The pool has approximately 41% invested in Canadian equities, of which 35% have call options written against them. Presently, 8% of the fund is in high yield bonds, 12% is held in NWM Balanced Mortgage, and 22% is in the PIMCO Monthly Income Fund. The fund has also written put options on a notional 57%.
Foreign equities were generally stronger in July with NWM Global Equity up 1.4% versus 2.0% for the MSCI All World Index and 3.6% for the S&P 500 (all in CAD). Of our external managers, Carnegie and BMO Asia Growth and Income were up 1.6% and 3.9% respectively, while Templeton Smaller Company, Edgepoint, and Cundill fell 1.2%, 1.0%, and 0.3% respectively.
NWM U.S. Tactical High Income returned 2.6% in USD (approx. +2.3% in CAD) and is approximately 40% invested in U.S. equities, of which 77% have call options written against them. Presently, 10% of the fund is in cash, 25% is held in high yield bonds, and 22% is held in the PIMCO USD Monthly Income Fund. The pool has also written put options on a notional 62%.
The REIT market was stronger again in August, with NWM Real Estate up 0.9%.
NWM Alternative Strategies declined approximately 0.3% in August (this is an estimate and can’t be confirmed until later in the month). Altegris funds Winton, Brevan Howard, Millenium, and Hayman were +3.9%, -0.1%, +0.3%, and -2.0% respectively. SW8 was down 6.5% while RP was down 0.1%.
NWM Precious Metals was down 1.3% with gold bullion essentially flat during the month.
High yield bonds fared well in August as institutional investors came back to the asset class following the previous month’s correction. The rally was more evident in the U.S. than Canada, however.
NWM High Yield Bond was up 0.4% in August with the BMO U.S. High Yield (Montegy) leading the way, up 1.2%, followed by PH&N up 1.0%, and BMO Guardian High Yield up 0.4%. Picton Mahoney was down 0.3%.
Global bonds were up marginally, with NWM Global Bond increasing 0.1%. The stronger Canadian dollar likely detracted from returns.
Short-term interest rates were virtually unchanged in August, but 10-year Canadas rallied and ended the month at 2.0% versus 2.16% at the end of July. NWM Bond was down 0.2% mainly due to a 1.2% decline in one of our credit oriented funds, Eastcoast. The short-term bond portion of the fund managed by PH&N was up 0.25%.
The mortgage pools continue to deliver steady returns, with the NWM Primary Mortgage and the NWM Balanced Mortgage returning 0.4% and 0.5% respectively for July. Both funds held considerable amounts of cash at month-end, 4.4% for the Primary and 8.0% for the Balanced, though this is down from last month.
NWM Preferred Share was up 0.75% for the month of August versus the BMO S&P/TSX Laddered Preferred Share Index ETF which was up 0.71%. The end of summer has been relatively tame in the preferred share market as the Government of Canada 5-year bonds remained unchanged at 1.52%.
The theme of redemptions continues to resonate through the market place with $7.77-billion across all issues redeemed this year, almost matching the $8.5-billion in issuance. We believe this imbalance will continue throughout the remainder of the year and the lack of supply should keep a firm bid on preferred shares.
August In Review
With the exception of Japan, equities were up across the board in August.
U.S. markets led the way, with the S&P 500 increasing 4% and topping the 2000 level for the first time ever. Canada was up a respectable 2.1% while Europe gained an equivalent amount.
All these returns are in local currency terms. In Canadian dollar terms, U.S. stock returns were a little lower as the Canadian dollar gained some ground against the greenback. Against the Euro, the Canadian dollar gained even more.
We understand why stocks are going up, particularly in Canada and the United States. The economy is getting better, slowly but surely, and should take corporate earnings with it.
Higher interest rates are a risk to stocks eventually, but historically the impact is greatest near the end of a tightening cycle, not the beginning. We concede the point, however, that rising rates are a risk and should lead to increased market volatility.
University of Chicago Professor Jing Cynthia Wu and Bank of America Merrill Lynch’s Fan Dora Xia argue that comparisons to previous tightening cycles could result in forecasters underestimating the impact to the economy when rates are finally raised.
Because the Fed Fund’s target couldn’t be set below zero, the Federal Reserve used other measures to stimulate the economy, such as forward guidance (promise to keep rates low for a long time) and quantitative easing.
As a result, the Fed Fund’s target was effectively less than zero, by a meaningful amount. Using the term “shadow fed funds rate,” Wu and Xia use long-term bond yields to derive where Fed Fund’s rates should be.
Presently, they peg the shadow rate at -2.8% and point out the tightening cycle has already begun with the wind down of the QE program. By the time the Federal Reserve actually signals their first rate increase, they would have already effectively tightened by 300 basis points.
Understanding this, we believe the Federal Reserve will be extra cautious in raising rates, and increases will be more measured than normal tightening cycles.
Most forecasters still believe the U.S. Federal Reserve won’t start increasing interest rates until mid-2015. But they will be going up, and recent economic news has been more positive, leading some to believe the Fed could act sooner.
What is perplexing is why bond yields have remained at historically low levels. In fact, not only has the bond market failed to discount eventually higher rates, but the opposite has occurred, with 10-year Treasury yields actually falling.
One explanation for falling yields is many feel the economy is not as strong as the numbers indicate and believe we are in a world of structurally lower growth.
Former U.S. Treasury Secretary Larry Summers refers to it as “secular stagnation” while PIMCO is using the term “New Neutral.”
Of course this explanation is at odds with the rising stock market. They can’t both be right can they?
While it is true that slow but positive economic growth could result in a Goldilocks economy (not too hot, not too cold), even if the new normal becomes the new neutral, rates still need to move higher.
Present monetary policy is set to address an economy in crisis mode, not neutral. Just moving to neutral will require rates to move higher.
Inflation in the Euro-zone fell to 0.3% in August and second quarter GDP was flat in the second quarter and has grown only 0.7% over the past year. Germany actually saw its economy contract 0.6% in Q2, and they are supposed to be the strong economy in Europe.
Comparisons to the U.S. economy are stark. Europe appears headed for deflation and declining industrial output while the U.S. is heading the other way.
While ECB President Mario Draghi recently cut lending rates again and announced a new “quantitative easing-like” program, the U.S. Federal Reserve is in the process of winding theirs down.
Interest rates in Europe have been coming down, and the ECB is signaling that they would like them to go even lower.
But if you are an investor and can invest anywhere in the world, why not buy U.S. Treasury’s versus German Bunds, or more to the point, Spanish government bonds?
U.S. Treasuries are considered the safest asset in the world, and yet the yield on 10-year U.S. Treasuries is around 2.4% versus 2.3% for Spanish 10-year bonds.
Even better, which currency would you rather hold: Euros or U.S. Dollars?
The ECB is desperate to devalue the Euro. Based on this tradeoff, one wonders why U.S. rates are as high as they are.
Capital flows are flowing – and will continue to flow – into the U.S. dollar and U.S. Treasuries.
It’s a global world, and declining European bond yields are driving U.S. bond yields lower.
Chinese industrial production decelerated to only +9% in July while the HSBC Purchasing Managers Index slumped to a three month low of 50.3, just barely in expansion territory.
Chinese exports in August increased 9.4% versus year ago levels, but indicative of a weak domestic economy, imports declined 2.4%.
Weighing on growth is a recent crackdown by the Chinese officials on corruption. In 2013, approximately 182,000 communist party members were investigated with about 25,000 being punished for “extravagant lifestyles.”
Bank of America economist Lu Ting estimates the resulting decline in luxury good sales could shave between 0.6 and 1.5% off China’s economic growth.
As for Japan — the only major market in negative territory last month — their GDP contracted 7.1% in the second quarter, but most of this decline was due to an increase in the national sales tax from 5% to 8% (which prompted consumers to buy whatever they could before the sales tax increase was implemented).
Predictably, this led to GDP growth of 6.1% in Q1.
What has investors worried is what consumers will do this quarter, or more precisely, what they won’t do.
Helping the cause is wages, which were up 1% in June, increasing for the fourth month in a row. Regrettably, adjusted for inflation and the sales tax increase, real wages were actually down 3.2%.
Also providing some optimism is trade with China, which is expected to increase for the first time in three years. But then, as mentioned above, the Chinese economy is not the pillar of growth it once was.
Japan needs structural reforms, and so far the Abe government has failed to deliver.
Stronger U.S. economic growth should help offset the prospect of eventual monetary tightening.
Equities are still more attractive than bonds, but we would expect volatility to be on the rise.
Help from Europe and Asia appears unlikely in the short term, which means the U.S. dollar should continue to strengthen.
The U.S. Economy
Second quarter GDP was revised up to +4.2% with non-residential fixed investment, which is essential corporate capital spending, up 8.4% from an initial estimate of +5.5%.
This is encouraging as business spending has been largely absent from the economic recovery.
Manufacturing was also strong with most indices moving further into expansion territory. The bellwether ISM Manufacturing Index indicated U.S. manufacturing activity in August was at its busiest level since April 2010.
The U.S. manufacturing sector continues to outpace growth in most developed nations.
After adding more than 200,000 jobs a month for six consecutive months, the U.S. employment market took a bit of a breather in August with a disappointing 142,000 new jobs added.
In addition, June and July totals were revised down by 28,000 jobs. Longer-term trends remain strong, however, and the unemployment rate continues to move lower.
Additional positive signs in the labour market include the continued decline in new jobless claims, which have fallen to levels not seen since before the recession. If workers who lose their jobs are confident they will quickly find another one, they are less likely to claim unemployment benefits.
U.S. companies are also finding it is taking nearly 25 days on average to hire workers – a 13-year high.
Also, San Francisco Federal Reserve economists Mary Daly and Bart Hobijn argue wage growth is being held back temporarily by “pent up wage deflation.” They believe wages didn’t adjust down enough during the great recession and thus employers are slow to increase them until a catch-up period is achieved.
Rather than signaling slackness in the labour market, low wage inflation could be understating building wage pressures in the economy.
The unemployment rate for 25 to 34 year olds with high school education or less was 9.6% in July, much higher than the overall workforce. But because many young people decided to go back to school during the Great Recession, only 2.6% of the U.S. population aged 25 to 34 with less than a high school education was unemployed in July 2014 compared to 4.4% in July 2009.
The unemployment rate for this demographic might be high, but it’s a smaller group.
Finally, one of the reasons wage growth has lagged is that many of the jobs created during the recovery have been in low wage industries.
According the National Employment Law Project, nearly 40% of jobs created in the last six months have been in higher wage industries like construction, manufacturing, and professional services.
Wage inflation is key in determining when and how quickly the Federal Reserve will increase interest rates.
While wage inflation remains low, we are starting to see sign that higher salaries are on the way.
Inflation looked to be on the move earlier in the year, but has since settled down with core CPI well below the Federal Reserve’s 2% target.
While we still believe interest rates will be moving higher next year, the lack of inflation means there will be less urgency to raise rates in the short term.
Like last month, however, stronger consumer confidence is not leading to more activity at the cash register; consumer spending contracted slightly in July, though it is still showing healthy gain compared to year ago levels.
Likewise, retail sales were flat versus June, and only slightly positive, excluding auto sales.
Overall, July retail sales posted their weakest month since January. A possible explanation for the divergence between consumer confidence and consumer spending could be that while the U.S. economy has added a lot of jobs over the past six months, wage inflation has been virtually non-existent while inflation has been moving higher.
Given inflation had pulled back and we may be seeing the start of higher wage gains, the prospects for increased retail spending are more promising.
New home prices were also softer compared to June, but still positive compared to year-ago levels. Existing home prices remain in positive territory, but gains have slowed.
Higher prices and tighter mortgage standards have continued to weigh on the housing market as the initial rebound from the housing crash transitions to a more sustained recovery.
Higher building permits and housing starts are encouraging, but a continued recovery in the job market should be the catalyst to move the housing recovery to the next stage of the recovery.
We believe the U.S. housing market is still in the early innings of a recovery.
The U.S. trade deficit in July declined with both exports and imports increasing.
Demand for American auto and industrial supplies helped drive exports higher while the petroleum deficit hit its lowest level since May 2009. The improved balance of trade bodes well for third quarter GDP growth.
Employment growth disappointed last month and the housing market recovery continues to be taking longer to play out than we hoped, but overall the U.S. economic recovery looks on track.
The Canadian Economy
Second quarter Canadian GDP grew 3.1%, its fastest pace in more than two and a half years.
The better-than-expected growth, led by household consumption, residential investment, and exports, confirms that the Canadian economy has recovered from the weather inflicted first quarter.
Over the past year, Canada has added a mere 81,000 jobs in total, or an average of just under 7,000 per month. Even worse, 80% of the new jobs have been part time.
The unemployment rate was unchanged, but the participation rate fell to its lowest level since November 2001 as the labour force declined by about 21,000 workers.
On the positive side, like the U.S., wage growth came in at 2.5%, the largest gain since February 2014.
Inflation eased in July as gasoline and food prices moderated. On a month to month basis, CPI declined for the first time since October 2013.
Retail sales continued to be strong in June as warmer weather boosted sales of seasonal goods like garden products. Also helping were higher beer and wine sales from World Cup celebrations. German beer was particularly popular. English lager, not so much.
An improving economy should help extend the housing cycle in Canada.
Higher interest rates, however, will be key to testing the resiliency of Canada’s housing market. The Bank of Canada can’t afford a policy mistake given how highly levered Canadians are.
Canada’s balance of trade continued to improve in July as auto part sales helped drive exports higher.
The weakness in the Canadian job market is a concern and we continue to wait for the housing market to slow.
Growth south of the border is encouraging, however, and should bring Canada along for the ride.