Highlights This Month
- What has fixed income investors concerned?
- International monetary policy and the current currency war.
- Sequestration, spending, and the U.S. budget deficit.
- Can Japan succeed with its “Three Arrow Plan”?
- China’s hope for a consumption-based economy is fading fast.
- Can the glass be half full for Europe?
- Economic growth in the U.S. looks modest at best.
- Is the U.S. housing recovery on track?
- May sees second largest number of new jobs created in Canada.
- Will there be a hard landing for the Canadian housing market?
The NWM Portfolio
It was a mixed month in May as equity-oriented assets performed well, while fixed income related assets traded lower.
It was not a good month for the bond market with interest rates moving higher. Yields on 2-year Canadas backed up from 0.92% at the end of April to 1.08% at the end of May. 10-year Canadas fared even worse, with rates at the end of May hitting 2.07% versus 1.70% at the beginning of the month.
The NWM Bond Fund was down only 0.1% as our short duration strategy helped mitigate the carnage. Also helping were our recent allocations to alternative investment-grade managers who take virtually no interest rate risk, but use leverage in building an investment-grade credit portfolio that should deliver higher returns.
High yield bonds had a decent month, with the NWM High Yield Bond Fund gaining 0.4% in May as higher coupon payments were able to more than offset interest rate losses during the month.
Global bonds did even better, with the NWM Global Bond Fund increasing 2.6%. A 3% decline in the Canadian dollar certainly contributed to this positive result. Given the recent sell-off in emerging market securities, next month’s result may not be as favourable.
As with high yield bonds, mortgage returns were lower than normal given the back-up in interest rates, but still positive given the higher coupon payments. The NWM Primary Mortgage and Balanced Mortgage Funds returned 0.2% and 0.5% respectively. Current yields (which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and are, in no way, predictors of future performance) are 4.5% for the Primary Fund and 7.2% for the Balanced.
Preferred shares were down slightly in May with the NWM Preferred Share Fund losing 0.1%. There were some large headwinds for the preferred market during the month of May with Government of Canada 5-year bonds moving up 32 bps to 1.48% and four new issues in the last three days of the month flooding the market with new supply.
The overall market has been selling off the past two months, and although volatility will probably continue, many preferred shares are much more attractive now, as issues have come back closer to par after trading at significant premiums. We will look to be a net buyer in this market and will focus on providing liquidity to sellers who are looking to fund their purchases of new issues.
Canadian equities were up in May with the S&P/TSX gaining 1.8% (total return, including dividends), while the Strategic Income Fund and Canadian Tactical High Income Fund gained 2.0% and 1.0% respectively.
The Strategic Income Fund’s (SIF) cash position is around 5%, but we are looking to write calls against more positions given current strength in the equity markets. Presently, about 14% of our Canadian positions are covered.
Foreign equities were mainly higher in May with the NWM Global Equity Fund gaining 4.2% versus 2.8% for the MSCI All World Index. The NWM Tactical U.S. Fund was up 1.4% with the S&P 500 increasing 2.3%.
Higher interest rates weighed on the REIT market with the NWM Real Estate Fund down 3.9%. Apparently no one likes high-yielding stocks anymore.
The Alternative Strategy Funds were mixed in May. Gold bullion was down another $48 in May, or 3.0%, after shedding nearly $140 an ounce in Canadian dollar terms last month. Gold stocks performed marginally better, with the NWM Precious Metals Fund down 2.7%.
If it’s any consolation, famed hedge fund manager John Paulson’s gold fund was reported to have lost 27% in May and is down 47% year-to-date. Most of that fund’s $360-million AUM is Paulson’s own money. The Alternative Strategy Fund (NWM 190) was up 1.9%.
May In Review
It was another strong month for equities in May, less so for bonds.
The S&P 500 and Dow Jones Industrial Average increased 2.3% and 2.2% respectively, and while the S&P/TSX continued to lag, it was still up a respectable 1.8%. Bond prices, however, moved lower with 10-year government bond yields in both Canada and the U.S. backing up sharply above 2%.
In addition, while bond yields have been moving higher, inflation has been moving lower. As a result, real interest rates have moved up, as evidenced by the increase in yields of inflation-protected bonds, or TIPS (Treasury Inflation Protected Securities).
What has fixed income investors concerned is speculation that the Federal Reserve will begin reducing monetary stimulus. Most believe the Fed will begin the process by “tapering” (the new buzz word in the capital markets) their current $85-billion-a-month bond shopping spree, possibly as early as the summer.
This has investors beginning to re-evaluate their allocations to bonds with Lipper Research reporting nearly $880-million redeemed from bond funds and ETFs near the end of May. Not everyone thinks the tapering will happen anytime soon, however, and for the entire month of May, investors continued to pour $15.2-billion into fixed income.
While the U.S. economy has strengthened, it has done so modestly, and spending cuts and tax increases mean GDP growth in Q2 and Q3 will probably slow. We are not so sure The Great Rotation has started in earnest and wouldn’t be surprised to see yields moving lower again.
Bonds were not the only securities feeling the heat from higher interest rates. Dividend paying stocks, which have been treated by investors as bond substitutes, also corrected in May. Particularly hard hit were utilities, telecommunications, and real estate investment trusts.
The broader market, however, continued to move higher and is up 74% over the past 46 weeks since the recession ended. This is much higher than the 46% average increase after the past 10 post-war recessions.
Valuations have also moved higher, with the price earnings multiple on the S&P 500 presently at its highest level since 2010, though still below the average since 1999. It’s not the economy that’s driving equities higher either. GDP has grown only 15% over the past 15 quarters, less than half the growth seen in past 10 economic recoveries.
Interestingly, the current strong move in equities comes at a time when earnings growth looks to have crested. It is estimated that first quarter earnings increased only 3.4% from last year and sales growth actually declined 0.2%. According to Factset, only 48% of companies beat analyst estimates versus an average of 52% over the past four years.
Despite this, with fixed income returns looking increasingly unappealing, investors don’t know where else to go. Valuations have moved higher, but are still reasonable. Earnings growth has stalled, but the economy should begin to grow again later in the year when the effects of sequestration begin to wear off.
Accordingly, investors allocated $22.4-billion into stock mutual funds and ETFs in May.
The debate on when the Federal Reserve should begin tightening monetary policy comes at a time when most countries are looking to ease, especially given Japan’s new bond buying program has resulted in pushing the Yen lower.
Countries are trying to keep their currencies competitive and a stimulative monetary policy is a popular tool for any central banker entangled in a currency war. The simple fact that the debate presently taking place in the U.S. is centered on when the U.S. will be actually normalizing monetary policy makes the U.S. an outlier and should help move the U.S. dollar higher.
Another area where the U.S. is looking more and more like an outlier is their budget deficit. The Congressional Budget Office (CBO) estimates the U.S. budget deficit for the year ending September 30 will shrink to a mere $642-billion versus estimates of $845-billion only three months ago and $1.087-trillion last year.
At 4.0% of GDP, the 2013 deficit would still be higher than historical averages, but a considerable improvement from last year’s 7.0% and 2009’s 10.1% deficit to GDP. Compared to most countries in Europe, the U.S. is looking downright miserly.
The CBO expects the deficit to continue to trend lower over the next few years before turning higher in 2016 as demographics begin to drive Medicare and Social Security materially higher. By 2023 it is estimated spending on these entitlement programs alone will hit $3-trillion, half the expected budget.
That said, 2023 is a long time from now, especially for Washington. Why deal with a problem today that can be put off until tomorrow, right?
It was hoped Congress might be forced into a negotiated “grand bargain” and lower future entitlement spending commitments, given the perception that the deficit posed a threat to economic recovery. Now with the deficit in retreat, there is less political pressure to take action.
In addition, improved budget estimates mean the U.S. will reach its legislated debt ceiling of $16.4-trillion later than previously estimated, such that the CBO now believes Congress could delay taking action until as late as October or November.
While we always believed the Republicans’ threat to use the debt ceiling as a bargaining chip to lower entitlement spending was a hollow one, it does push further out a debate that needs to take place.
The Sequester spending cuts helped in the short term, but the real battle over entitlement spending cuts is still to come.
In order to shake the country out of a 15-year deflationary funk, Prime Minister Abe is in the process of implementing a “three-arrowed economic booster plan,” comprised of fiscal policy ($131-billion spending package), monetary policy (BOJ to buy $70-billion of Japanese government bonds per month) and structural reforms.
So far, the plan looks to be working. First quarter GDP grew 3.5% (later revised to 4.1%) and consumers have started to loosen their purse strings, particularly on recreation, cars, and dining out. Sensing improved earning, the Japanese stock exchange exploded higher and by mid-May, the Nikkei was up 70% since November.
Prime Minister Abe was looking like a super hero and his approval rating soared to over 70%, which is important in a country where the last six Prime Ministers (including Abe himself in 2006-7) have lasted an average of about a year.
Mission accomplished? Not so fast. One of the unintended consequences of Abe’s three arrow plan has been a weaker Yen. Ok, maybe a weaker yen was part of the plan all along. Don’t tell China and Korea.
What was also planned was that the government bond buying program would drive bond yields lower. It’s kind of the whole idea of quantitative easing: buy a whole bunch of bonds, drive the prices up (yields down) and get consumers to borrow money and consume more.
More importantly, by also targeting a 2% inflation rate, real interest rates were expected to decline. So far, this hasn’t happened as bond yields have started to moved higher, not lower. This can’t be considered a big surprise given the stated desire to target a higher inflation rate, and could actually be construed as a sign Abe’s policies are working.
Remember, however, Japan’s public debt is around $10-trillion, or 245% of GDP. If nominal interest rates were to spike sharply higher, interest costs would quickly swamp the Japanese government’s ability to keep up, and some form of default would likely to follow.
Recent comments by the Japanese Finance Minister and minutes from a recent Bank of Japan meeting indicate some discomfort with the recent rise in yields leading traders to question Japan’s fortitude in driving inflation higher.
Who can blame them? It’s a dangerous game.
Ultimately, we believe success will depend on Abe’s third arrow: structural reform.
Japan has one of the most inflexible workforces in the developed world with strict labour laws, low female participation rates, and a tradition whereby employees of large corporations can expect jobs for life. No one gets laid off.
A government survey conducted in 2011 estimated 4.6 million jobs in Japan were unnecessary. Case in point, seven Japanese firms still manufacture flat-panel TVs even though almost all lose money doing so. Company executives privately concede the reason they haven’t thrown in the towel is that they would need to find other jobs for those currently making televisions.
There is also very little entrepreneurship in Japan and new business startups are amongst the lowest in the developed world. On June 5th, Abe finally unveiled the blueprint for his third arrow, but it fell short of the target and provided only modest labour reforms and corporate tax relief.
The Nikkei, which had already corrected almost 13% from its high on May 22, proceeded to give back another 5% over the next few trading days. Perhaps the Nikkei got a little ahead of itself.
The economy in Japan is looking stronger, but Abe’s three arrow plan is aggressive and not without risk. Brace yourself for more volatility.
GDP is expected to grow only 7.8% in 2013 as industrial production continues to trend lower. According to the HSBC purchasing managers index, manufacturing in China is actually contracting.
China’s goal of rebalancing towards a more consumption based economy appears to be falling short of expectations as household consumption comprised only 35.7% of Chinese GDP in 2012, unchanged from the previous year.
Fixed investment, however, increased to 46.1% versus 45.6% in 2011 as capital spending continues to be the main driver for China’s economy. In order to maintain this growth, China has been borrowing more and more money.
Household, corporate, and local government debt as a percent of GDP is estimated to have increased from 128% in 2008 to 180% in 2012. Total financing is estimated to have increased 52% in the first five months of 2013 alone, and the economy still looks like it is slowing.
China is taking on more debt, but is getting less economic growth in return. Chinese officials have started to take notice and are trying to curtail unconventional lending.
China isn’t alone in running up their debt, however. Emerging Asian economies have seen their debt-to-GDP ratios increase from 133% in 2008 to 155% by mid-2012. Where is the money coming from? Well the Federal Reserve and their quantitative easing program, of course.
What happens to these markets when the U.S. reduces their stimulative monetary policy and liquidity dries up? Good question. Maybe Japan’s quantitative easing program will take over for the Fed and provide liquidity?
Traders aren’t waiting around to find out. They are starting to sell emerging market bonds now.
So what about Europe? With so much going on regarding what the Fed might do, a potential slowdown in China, and big policy moves in Japan, we can take comfort from the fact that it is status quo in Europe – which unfortunately means recession.
We choose, however, to take a glass half full view of Europe this month. After all, things have to get better eventually, right? The EU appears to be coming to the conclusion that austerity is not the answer and is only making the current situation worse.
The EU recently gave France, Spain and the Netherlands a two-year waiver on the annual 3% government deficit limit. Even Germany is starting to come around, with German Finance Minister Wolfgang Schauble recently quoted as saying “we need more investment, and we need more programs.”
It appears Germany is finally coming to the realization that the Euro Zone risks losing an entire generation of workers in Southern Europe if action isn’t taken. Reforms are still needed, but the damage currently being done by more austerity is too great. At some point, Europe is going to have to cry “uncle.”
Argentina sustained an 8.4% decline in GDP before it abandoned its dollar peg in 2002. Italy is nearly at this point and Greece is well beyond. If Germany wants to save the Euro, they are going to have to loosen their purse strings.
The U.S. Economy
Consumer spending continued to be the main driver of growth with personal consumption revised up to +3.4% versus previous estimates of 3.2%. Government spending, on the other hand, continues to hurt economic growth, with the Commerce Department estimating a negative 1% impact on first quarter GDP growth.
Most economists fear the impact from the Sequester spending cuts have yet to be felt and the biggest impact will hit this summer with second and third quarter GDP growth expected to be slower than the first quarter.
Disturbingly, manufacturing activity appears to be slowing already, with ISM Purchasing Managers Index falling below 50 in May, thus indicating the manufacturing sector in the U.S. is contracting.
Overall, economic growth in the U.S. looks modest at best. Perhaps the equity markets are looking past the current weakness?
May’s employment report came in higher than expectations with 175,000 new jobs created, but the unemployment rate went up as more workers entered the labour force than found jobs.
April’s job tally was revised slightly lower, but overall it was a pretty solid month. It was strong enough to keep some positive momentum in the job market, but not too strong to suggest an imminent change in Fed policy. Goldilocks would have been pleased.
Lukewarm, however, isn’t going to get America back to where it needs to be anytime soon. If current forecasts are right and the U.S. creates 180,000 new jobs each month, it will take until mid-2014 before the U.S. is able to finally replace the jobs lost during the recession. Adjust for population growth, and we are an estimated nine years away.
Yes, the unemployment rate is coming down, but only because workers have stopped looking for work. The labour participation rate has fallen from 63.4% in 2006 to 58.6 presently and has barely increased from the July 2011 low of 58.2%.
Youth unemployment, already unacceptably high at 16.1%, would jump up to a Europe-like 22% if one were to add back the 1.5 million youth that have dropped out of the labour force. The U.S. is creating jobs, but it’s hardly a robust recovery.
Well, if the U.S. economy is recovering, you sure wouldn’t know it by watching the inflation rate.
Headline CPI was negative again in April as energy prices continue to move lower. Also declining were apparel prices and personal computers. Core inflation (excluding food and energy) was more stable, but is also continuing to move lower.
The declining inflation rate gives the Federal Reserve more room continue buying bonds, if they so choose. With the unemployment rate a good 1% away from their 6.5% target and inflation going lower, we don’t see why they would be in any hurry to stop.
Cheap gas is good for consumers, and this was evident in May’s consumer sentiment indices. Also helping the consumer’s mood is a stronger housing market.
With lower gas prices leaving more money in their pockets, Americans have been doing what they do best: spend. April retail sales were strong versus last year and warmer weather has helped May same store sales move higher.
The savings rate is still far too low, but what is good for GM is good for America, right?
The housing recovery remains on track with sales and prices continuing to move higher. Corelogic estimates 850,000 homeowners moved into a positive equity position in Q1 while 1.7 million have moved into the black over the past year.
The number of Americans who still owe more than their home is worth still numbers approximately 9.7 million, or 19.8% of all residential properties with a mortgage, but is down from 10.5 million, or 21.7% at the end of 2012.
Housing starts were lower in April, but permits were higher. Zelman & Associates estimates the U.S will need 14 million new homes this decade, but fear only 5.7 million will be built by 2015. This means the U.S. will need to build 2 million homes a year from 2015 to 2020.
Assuming, of course, these new potential homeowners will be able to get mortgages.
The trade deficit widened in April as America’s fondness for foreign-built cars and cell phones grew faster than demand for American-made goods.
Weak global economic growth continues to be the problem, with export growth up only 0.8% so far in 2013. Exports to the European Union are down 7.4% in 2013 and off a shocking 20% to the U.K.
Overall, not a great month for the U.S. economy. We think the increase in interest rates may be discounting an improvement in the economy that might be a little slower in developing than investors think.
The Canadian Economy
Canadian GDP grew a healthy 2.5% in Q1 and March was a respectable 0.2%.
Growth was led by the export sector, which is a good thing given the domestic economy looks to be faltering.
Construction contracted 4.7% in Q1 and retail spending grew only 0.9% versus 2.5% in the second half of last year. This highlights the fact that the strength of the U.S. economy will be key for Canada.
Canada created 95,000 new jobs in May, the second largest total ever. While this is an outstanding result, we would point out that monthly Canadian job data has been very volatile of late and the six month moving average growth rate is a more normal 19,000.
Also interesting is the fact that the construction industry added 43,000 jobs, a total that looks unsustainable to us, given the slowing housing market in Canada. For the seventh month out of the last nine, the manufacturing industry cut jobs, with 14,200 positions being eliminated.
Going forward, we would expect the construction industry to shed workers as the housing sector continues to cool and we would hope the manufacturing sector adds workers as the U.S. economy continues to recover.
Lower gasoline prices, down 6% versus last year, continued to be a major factor in driving inflation lower in April.
Most categories exhibited slower growth, however, as even food prices increased only 1.5%. Interestingly, a recent Royal Bank survey found 84% of respondents believed food prices had increased over the last year with 91% planning to reduce spending and make smarter decisions.
Not sure if that means they plan to buy cheaper food or food that is better for them. Vegetables seem very expensive to me.
Retail sales were flat in March, but volumes were up 0.7%. Compared to last year, retail sales appear to have decelerated. While we believe this is partially due to lower gasoline prices, we also think Canadians have got the message that they need to reduce their debt load.
Consumer debt in the first quarter fell 2% and was up only 3.5% over last year. The decline in the first quarter may seem modest, but it was the first decrease since Q3 2011 and the largest decline since TransUnion started tracking this data in 2004.
Statistics Canada estimates the household savings rate in Q1 2013 was 5.5% versus 5.4% in the fourth quarter 2012 and 0.9% in Q1 2005.
We still do not see a hard landing developing for the Canadian housing market. According to the Terenet-National Bank Home Price Index, prices in April were up only 0.2% compared to March, the second weakest increase in the 15-year history of the index.
Home sales, however, moved higher; and Toronto and Vancouver, the two markets people fear the most, look like they could be stabilizing. Sales in Toronto were only down 2% in April (versus last year) compared to declines of 15% and 17% the previous two months, and prices were actually up 3%.
In Vancouver, sales were 6% lower versus declines of 18% in March and 29% in February, and prices were described as trending modestly higher.
Canada’s trade balance in April remained in a deficit position for the 16th month in a row. Lower exports were the reason, with Canada’s trade deficit with the rest of the world (excluding the U.S.) increasing $600-million in April to $4.4-billion.
Overall, investors appear to be looking past the current U.S. economic weakness and are giving U.S. equities the benefit of the doubt.
It’s the opposite in Canada. Investors are looking past the current strength and are discounting a slowdown in the future. The housing sector will slow, but will it slow enough to offset the benefit of a stronger U.S. economy? Stay tuned.
What did you think of May’s market activity? Let us know in the comments below!