Such Great Heights - Nicola Wealth

Such Great Heights


Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

It was again a “risk on” month in February.

Just when you thought bonds’ best days were behind them, they deliver very respectable returns with the NWM Bond Fund up 0.6%.  Short rates rallied with two-year Canada’s going from 1.16% at the end of January to 1.0% at the end of February.  Ten-year Canada’s also rallied, with yields declining from 2.0% to 1.84%.

High yield bonds continue to deliver good results, with the NWM High Yield Bond Fund gaining 0.9% in February.  Credit spreads continue to narrow, but a correction at some point should be expected.

It gets tougher from here for the bond market.  A month like we saw in February will be hard to duplicate in March.

Mortgage returns were steady in February.  The NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund produced identical 0.5% returns.

Canadian equities were stronger in February with the S&P/TSX gaining 1.26% (total return, including dividends), while the NWM Strategic Income Fund returned 2.6% and the NWM Tactical High Income Fund CAD was 0.4% higher.  As expected, the return for the Tactical Fund is lower given its mandate to generate income through covered call and naked put writing.

We continue to run the SIF more aggressively.  We sold assets, so the 6% cash weighting is all cash and money market.  We expect to see this allocation come down a bit more, but probably not below 3%.  A cash weight between 3 to 5% would be a good near term range.

We still look for opportunities to write covered call options, but are happy to let the portfolio run a bit in this market.  We are currently only 10% covered.  The downside to this strategy, however, is the projected yield is currently below 4.5%.

Foreign equities had another strong month in February with all of our external funds posting positive returns during the month.  The NWM Global Equity Fund gained 4.2% while the MSCI All World Index was up 3.1%.

The NWM Tactical High Income Fund USD (which is not part of the NWM Global Equity Fund) was up 2.3% (CAD).  A good result, given the income/cash flow strategy and the fact the S&P 500 was up 1.4% (CAD).

Real estate again lagged the equity markets with the NWM Real Estate Fund up 0.4%.  Nevertheless, still positive.

The alternative strategy funds were mixed in February.  Gold bullion was down 2.1% in Canadian dollar terms, but gold stocks declined more, with the NWM Precious Metals Fund down 9.4%.  The NWM Alternative Strategy Fund was up 2.7%.

We continue to be disappointed with gold stocks.  We believe negative real interest rates are the biggest positive driver for higher gold prices.  As nominal bond yields moved higher last month and inflation remained static, we believe the market became concerned that real interest rates would continue to move higher and thus began to sell gold.

Also, with comments from some Federal Reserve officials signaling QE3 might come to an end sooner rather than later, central bank money printing (also a positive driver for higher gold prices) became less of a catalyst for higher gold prices.

However, real interest rates moved lower in February and Bernanke confirmed his commitment to QE3, so we were disappointed in gold’s negative performance during the month.  Some high profile investors and hedge funds have been selling gold and a stronger equity market has been drawing potential gold investors away.

We still think gold has a place in a client’s portfolio as insurance against the erosion of purchasing power from excessive money printing and negative real interest rates.

Longer term, if the U.S. was to cut entitlement spending and improve their longer term debt to GDP ratio and real interest rates were to turn positive, we may look to re-evaluate our gold position.

Until then, in gold we trust.

February In Review

By Rob Edel, CFA

The markets followed up January’s strong start to the year with further gains in February.

The S&P 500 and Dow Jones Industrial Average advanced 1.4% and 1.8% respectively while the S&P/TSX was not far behind with a 1.3% return.  The Dow, in fact, soared to a record high in early March, topping levels last seen in October 2007.

MMC-2013-2-Crossing the Line

It’s all a matter of perspective, however.  If one were to factor in dividends, the Dow has been breaking into unchartered territory since last year and every increase is a new all-time high.

MMC-2013-2-New Heights

Adjusting for inflation, however, the nominal record high for the Dow wasn’t October 9, 2007 but rather January 14, 2000.  While in nominal terms, the Dow is up 22% since January 2000 adjusted for inflation, it’s actually down more than 10%.

MMC-2013-2-Inflated View

For the record, the S&P/TSX is a good 15% from its June 18, 2007 nominal high.  The S&P 500 has also yet to break into record territory, but it’s tantalizingly close and current upside momentum could easily push the S&P 500 over the top by the time this commentary hits your inbox.

It’s been well over 500 days since the S&P 500 has suffered a 10% correction, which according to Birinyi Associates, has only happened on five other occasions.

If history is a guide, the near term looks pretty good as these five occasions resulted in average gains of 9.2% over the following 6 months and 13% over the ensuing 12-month time periods.

Birinyi points out positive returns in both January and February are also a pretty good predictor of positive future returns – in all 26 previous occasions this has occurred, the market has ended the year in positive territory and averaged a tidy 24% return.  In fact, on only two occasion did the market fail to hit double digits, 1987 and 2011.

The performance of the markets is impressive, especially in light of some of the negative news in February and early March.  As expected, the March 1 deadline for avoiding the $85-billion across-the-board spending cuts (aka sequestration) came and went with no deal.

While it is true the cuts are expected to be less of a cliff than a gradual decline, with the Congressional Budget Office estimating only about $44-billion in cuts to take place over the next 7 months, they still estimate a 0.5% hit to GDP in 2013.

Add in the increase in the payroll tax and roll back of the Bush tax cuts for the rich that took effect at the beginning of the year, and many economists are forecasting a 1.25% hit to GDP growth this year.

For 2014, the CBO estimates government spending will fall 2.5% and Macroeconomic Advisers estimates about 700,000 jobs could be lost by the end of 2014.

Want to hear some more bad news?  The results from the Italian election are in, and they couldn’t have been worse.

Hopes of a pro-austerity/reform coalition between Centre-Left Democrats led by Pier Luigi Bersani and technocrat incumbent Premier Mario Monti were dashed as Monti managed to procure a mere 9% of the vote in a clear rejection of his austerity and reform minded policies.

What doomed the potential coalition was the surge in popularity of ex-comedian Beppe Grillo, who campaigned on a policy of scrapping the Euro in favour of a return to the Lira and restructuring Italy’s crushing €1.9-trillion public debt.  Grillo’s party slogan, in fact is “vaffa”, which loosely translated means “f**k off!”  Charming.

Also picking up support was conservative leader and disgraced ex-premier Silvio Berlusconi, who also vowed to do away with austerity plans.  Together, Grillo and Berlusconi garnered 57% of the vote, hardly comforting for the rest of Europe counting on continued austerity measures.

Fortunately, it is unlikely Grillo and Berlusconi will find enough common ground to work together and Italians will likely be heading back to the polls.  In the meantime, Europe is left to ponder Italy’s fortitude in regards to economic reforms and question why they should hold Italians bonds.

The European Central Bank’s Outright Monetary Transactions (OMT) program, which promised unlimited support from EU bailout funds in exchange for tough reforms mandated by the EU, can’t be initiated if there is no government to negotiate with.

Fortunately, the bond market has yet to panic.  After an initially spiking to nearly 5%, Italian 10-year bonds have rallied back to 4.6%.  Quite frankly, we are surprised that market is taking this so well.

MMC-2013-2-Italian Government 10 Year Bonds

As for the rest of Europe, growth continues to look challenged, with the European Union recently predicting GDP will shrink for the second year in a row in 2013 before growing only 1.4% next year.  Austerity is taking its toll and Italian voters are the only ones that could be looking for relief.

MMC-2013-2-Expecting a Squeeze

For now, most Europeans want to stick with the Euro, but patience is wearing thin.  It’s still the number one risk that we see for the capital markets.

While we generally consider China to be a good news story, it also has been looking a little shaky lately. 

After peaking in early February, the Shanghai Composite Index has been falling, most likely due to signals from Beijing that it is poised to tighten monetary policy.  Property sales are up 77.6% year-over-year in January and February, and prices are soaring.

In Shanghai, for instance, prices are up 41% with Beijing not far behind.  Even worse, inflation jumped to 3.2% in February versus 2% in January.  This is unacceptable.

Despite the fact that industrial production growth in January slowed to 9.9% versus 10.3% in December and retail sales were up only 12.3% versus 15.2% in December, it’s inflationary fears that will rule the day in China.

High inflation leads to social unrest, and there is nothing Chinese leaders fear more than social unrest.

MMC-2013-2-Shanghai Composite Index

So why is the market going higher?  Cheap money and quantitative easing by the Federal Reserve.

Investors have hitched a ride on the QE3 and are buying riskier assets.  How else are they going to get a decent return on their investments?  Certainly not in bonds.  Rates are low, and the Federal Reserve seems in no hurry to raise them.  Or are they?

While the Fed has vowed to keep rates low until the unemployment falls to 6.5%, rogue comments from some Federal Reserve officials are questioning this resolve.  Could the current policy lead to future asset bubbles?  How will the Fed unwind its bloated balance sheet once economic growth starts to accelerate?  Does it even work?

Nobody knows the answers, but any sign the Fed is starting to shift its policy away from low interest rates will be a key test for the markets.  Stronger economic growth will ultimately be good for markets, but higher interest rates will be a short-term headwind at minimum.

Don’t forget to wear your life jackets.  It could get rough.

MMC-2013-2-Living in a Low-Rate World

Strong earnings and better economic numbers, particularly employment and housing, are also helping move the market higher, but the Fed’s accommodative monetary policy is the main driver.  Europe continues to be the biggest risk while we would rate China as neutral.

The U.S. Economy

MMC-2013-2-Economic Growth-Table-US

Fourth quarter GDP was revised slightly higher to positive 0.1% from the previously reported 0.1% contraction as international trade came in better than expected.  For all of 2012, GDP grew 2.2% versus 1.8% in 2011.

While lower government spending is confining growth in 2013 to around 2%, so far the manufacturing looks to be in good shape with most purchasing manager indices indicating expansion.  If housing and employment continue to improve, GDP growth could surprise on the up side.

MMC-2013-2-Growth Factors

MMC-2013-2-Employment-Table-US

Employment was also looking strong in February.  At 7.7%, the unemployment rate fell to a four-year low and the U.S. created a better-than-expected 236,000 jobs.  January’s tally was revised down to 119,000 versus the 156,000 previously reported, but December was revised slightly higher.

It is the third month in the past four that the U.S. has delivered job growth in excess of 200,000.  Bond guru Bill Gross estimates average job growth of 200,000 per month should equate to real GDP growth of 3%, so this is very good news.

Gains were broad based with the construction sector adding 48,000 jobs, healthcare retail 32,000, and retail 24,000.

The only negative aspect to February’s report was gains were dominated by part time jobs and the decline in the unemployment rate had more to do with workers giving up their search for a job rather than finding a new one.

MMC-2013-2-Back to Work

MMC-2013-2-Inflation-Table-US

Inflation remains well under control.  There is some concern that gasoline prices have been moving higher, but we would suggest most of this move is seasonal with refining capacity shifting from heating fuel to gasoline as the summer driving season approaches.

MMC-2013-2-Retail Gasoline Price Trends

MMC-2013-2-Consumer Confidence-Table-US

Consumers continue to take their cue from the housing and employment markets as consumer confidence moved higher in February, despite low wage growth and higher gasoline prices.  This is good news for retailers.

MMC-2013-2-Consumer Conundrum

MMC-2013-2-The Consumer-Table-US

Well, maybe not good news for retailers in the short term.  The payroll tax increase and expected delay in getting tax rebates into the hands of consumers is taking a bite out of retail spending in January and February.

Retailers had to use more promotions in order to clear winter inventory to make room for spring merchandise.  A leaked email from a Wal-Mart executive called February “the worst start to a month I have seen in my 7 years with the company.  Where are all the customers? And where is their money?”

Unfortunately for Wal-Mart, their average customer is lower income consumers who are more impacted by small changes in earnings.  Fortunately for most retailers, the Labor Department estimates the top 20% of earners account for approximately 38% of all spending.

And the rich are getting richer.  U.S. household net worth rose 1.8% in Q4 of last year to its highest level since before the start of the 2007 recession.  Higher stock and house prices were the driver as real estate assets climbed $450-billion and stocks tacked on $150-billion in Q4.

When consumers feel wealthier, they spend more.  They also tend to borrow more, which also helps retail spending.  Household debt rose 0.3% in Q4 2012, the first increase since Q4 2008.

MMC-2013-2-Debt Load PartI MMC-2013-2-Debt Load PartII

This is positive news for the U.S. economy and has many economists wondering whether household de-leveraging is coming to a close.

MMC-2013-02-Housing-Table-US2

We continue to be bullish on the housing market in the U.S.  While prices moved down marginally in January and housing starts eased slightly, the pickings are getting pretty slim for buyers as the inventory of previously owned homes for sale is at a 13-year lows.

Investors have scooped up most of the high quality distressed homes and many owners are reluctant to list their homes, fearing prices will continue to move higher.  This will result in more new homes being built, which is very positive for the U.S. economy.

MMC-2013-2-Trade-Table-US

The trade deficit narrowed to its lowest level since January 2010 in December as higher coal exports to Europe and the lowest crude oil import volume in 16 years helped narrow the gap.

The shale oil and gas boom is helping turn the U.S. into an energy exporter versus an energy importer.  This is long term positive for the U.S. dollar.

The Canadian Economy

MMC-2013-2-Economic Growth-Table-CAD

While Canadian Q4 GDP came in at a paltry 0.6%, it was still higher than the 0.1% increase in U.S. GDP, and was in fact highest in the G7.  For all of 2012, GDP grew 1.8% and a slowing housing sector means Canada will be challenged to duplicate this in 2013.

Most Economists are forecasting sub-2% GDP growth for Canada in 2013.  Still, we are encouraged that the manufacturing sector appears to be holding up and a stronger U.S. economy and weaker Canadian dollar should help.

MMC-2013-2-Employment-Table-CAD

Canada created over 50,000 jobs in February, more than offsetting January’s losses.  The quality was also high, with 33,600 full-time positions added versus 17,200 part-time jobs.

The manufacturing sector lost 26,000 jobs while the professional, scientific and technical sector added 26,000.  The accommodation and retail sector was also strong, adding 21,000 positions.

We are concerned that the Canadian economy is slowing, but this report shows no sign of it.  We would point out, however, that construction jobs make up 7.3% of Canada’s total employment in January and a slowing housing sector could curtail future gains.

MMC-2013-2-Exhibit 4 Employment

MMC-2013-2-Inflation-Table-CAD

Inflation remains a non-issue in Canada. Inflation was below the Bank of Canada’s 2.0% target for 10 consecutive months now.  One explanation for lower inflation in Canada is increased competition from U.S. retailers.  About time!

MMC-2013-2-Consumer Confidence-Table-CAD

MMC-2013-2-The Consumer-Table-CAD

There was a surprise decline in retail sales in December.  Even excluding auto sales, retail sales declined 0.9%.  A strong November probably stole some business from December, but this is still a concern.  Lower prices in anticipation of Target entering the market likely contributed, as did increased cross-border shopping.  Perhaps Canadians are starting to de-lever?

MMC-2013-2-Housing-Table-CAD

Perhaps the imminent demise of the Canadian housing market has been largely exaggerated?  Existing home sales in January were up versus December, as were building permits and housing starts in February.

Toronto and Vancouver continue to be considered the Achilles heel of the Canadian housing market.  The Real Estate Board of Vancouver reported a 29.4% decline in sales versus last year, nearly 31% below the 10-year average for February.

Since peaking in May, the MLS Home Price Index has fallen 5.6%. For its part, the Greater Toronto Realtors Association reported sales declined 15%, but prices moved slightly higher.

Without higher interest or higher unemployment, we don’t see a U.S.-style crash in the housing market; lower building activity and flat or slightly declining prices, maybe.

TD recently issued a forecast calling for annual price increases over the next decade to average a mere 2%, considerably lower than the 5.4% average since 1980.  Vancouver is also heavy influenced by offshore investors, as can be seen in the chart below, and a decline in GDP growth in China could result in less spending power by Chinese investors.

MMC-2013-2-Exhibit3 Housing Starts

MMC-2013-2-Trade-Table-CAD

The trade deficit narrowed in December as volumes of both exports and imports declined.  Canada’s trade surplus with the U.S. narrowed but our trade deficit with other countries narrowed as exports increased 8.5% to $10 billion.

A softer housing market and lower consumer spending is inevitable.  This should make it hard for Canadian GDP to keep pace with growth in the U.S.  We don’t see a U.S. style housing crash or a recession, but household de-leveraging should result in challenged economic growth over the next few years.


What did you think of February’s market activity? Let us know in the comments below!