On April 28, we hosted our 2021 Virtual Strategic Outlook event, A Year In The Shadow of Covid-19.
We were fortunate to have many excellent questions posed for our Q&A session but could not answer them all due to time constraints. The following are responses to the questions we received, those with thematic overlap have been combined. Over the course of the next few weeks, we will also be digging into some of these topics in greater detail.
Does cryptocurrency or other emerging industries play a role in the future of Nicola Wealth?
John: We do not see cryptocurrencies playing a part in our asset allocation mix for clients. While it has risen more than 500% in the last year, it also fell 85% between December 2018 and the summer of 2019 and took more than 2 years to recover. Oil prices are also up 500% since last April. Copper, steel and lumber are all commodities that have seen major price increases over the last year. Investing in Bitcoin for us is speculation on future price increases since it does not generate any income and consumes vast amounts of energy to be created. We believe we understand the asset quite well and have chosen not to recommend investments that can only generate a return from price appreciation. This type of risk and volatility is not something we want to pursue on behalf of our clients.
What do you see regarding the value of the Canadian dollar?
Rob: The Canadian dollar has been appreciating versus the US dollar for a number of reasons. First, the Canadian dollar is considered a cyclical currency versus the safe-haven US dollar. A recovering global economy favours more cyclical currencies that have greater exposure to commodities, like Canada. In addition, interest rate and unemployment differentials between Canada and the US favour Canada in the shorter term with the Bank of Canada announcing plans to begin tightening monetary policy while the Fed remains very dovish. Longer-term, we have some concerns over the need for the Canadian economy to diversify away from real estate and commodities, as well as the future economic drag of an overleveraged consumer. A stronger currency would be counterproductive in addressing these issues.
What is the forecast for CAD vs USD – 1yr, 5yr?
Rob: Forecasting currency levels are always very tricky given the numerous influences and factors impacting the FX markets. Having said this, a range for the Canadian Dollar of 80 to 85 cents would appear fair from our perspective, so we wouldn’t expect large moves from current levels. The recent trend has been for the Canadian Dollar to move higher, so there is a risk it overshoots fair value in the short term, but we would be more cautious above 85 cents. Longer-term levels will depend on economic growth and inflation differentials between the US and Canada.
Is there any fear that the US has gone too far with stimulus and inflation could impact their position as the world’s reserve currency?
Rob: While the growth of US debt and the potential for inflation is a factor that needs to be monitored, we don’t see it jeopardizing the reserve currency status of the US dollar in the immediate future. There really aren’t any alternatives at the current time.
We tend to look at National debt and compare it with the debt of other countries, but wouldn’t it be more accurate to compare the total national and provincial debt? Or perhaps debt on a per capita basis?
John: In the presentation we did there are slides showing combined provincial and federal debt. In Canada’s case, both should be included for any fair comparison with other countries.
The presenter mentioned that all debt is NOT eventually paid back. Why is this and what is the significance of the debt (for instance all the COVID governmental programs) are not paid back?
John: There are times when governments run a surplus and overall debt for a particular country is reduced in absolute terms. Over the last two centuries that has been a rare event for most developed nations and over time total debt has increased. However, if the economy grows as fast or faster than the debt, then the ratio of debt-to-GDP would drop over time even as the number of debt rises. There is likely a limit to how much debt any country can accumulate (although Japan at almost 250% of debt-to-GDP seems to defy that theory). Overall, most developed countries have still not repaid the debt they incurred because of World War II, they have simply rolled it over.
Can you please explain why the government should keep taxing more? They can increase their debt instead.
John: We do not believe the government should tax more. We do believe they should spend better and manage their resources more effectively. In Canada, total national, provincial, and local taxes were approximately 45% of average household income in 2019, according to the Fraser Institute. Debt can be increased over time as long as it is responsible and ideally grows at a lower rate than the overall economy. Since it has been a multiple of economic growth for both 2019 and 2020, governments globally need to develop responsible plans for managing debt without reverting to increasing taxes.
Give a couple of specific changes you would make in the Core Nicola Portfolio.
Rob: The Nicola Core Portfolio Fund is an actively managed fund with tactical changes being implemented as appropriate. While we are always discussing and evaluating potential changes, we don’t have any changes currently pending given our current outlook.
Will equity be reduced in the Core Portfolio as inflation increases?
Rob: Certain equities can actually be a good inflation hedge and portfolio diversifier. While we may shift some allocations within our underlying equity funds, we have no current plans to reduce equities overall.
At the end of Rob’s presentation, he mentioned that if we see an increase in inflation it would mean portfolio construction should change, can he expand upon what changes would be made?
Rob: For the industry, there is more reliance on the typical 60/40 asset allocation, where bond allocations help offset the risk of equities. If inflation trends higher, bonds may no longer be able to play this role and investors will need to re-think portfolio construction. Our asset mix already reflects a more diversified portfolio and a relatively low allocation to traditional fixed income and interest rate risk.
Based on Rob’s forecast, what’s the suggested asset allocation for the next 12 months?
Rob: The asset mix of our Nicola Core Portfolio Fund is always considered the starting point for client asset mix. Based on the individual client’s unique needs and financial circumstances, the assets mix is tailored accordingly.
Are the various US returns stated for Real Estate, indexes etc, adjusted to CAD returns, or were you perfectly hedged?
Rob: Returns for the Nicola US Real Estate LP is reported in US dollars, with no hedging. All returns for Nicola Canadian Real Estate LP, Nicola Value Add Real Estate LP, Nicola Managed Real Estate Fund, and Nicola Global Real Estate Fund are reported in Canadian dollars and we do not hedge any of the underlying currency exposure.
The development of utility-scale batteries is technologically risky and upgrading power grids is politically fraught. Nuclear (fissile, not fusion) power is the only proven green power source that can scale sufficiently to meet demand. Is Nicola factoring promising technologies, like travelling wave reactors, into its strategy?
Rob: We are not making any direct investments in nuclear at the present time, but it is an area we continue to monitor and evaluate.
It’s been said that in a high or hyperinflation scenario, holding hard assets is less desirable than holding cash; that holding cash is more secure. Does it make sense to increase the proportion of cash in the strategy?
Rob: It depends on the path of real interest rates. Short-term real interest rates are presently negative, which makes cash an undesirable asset. Only if nominal rates increase more than inflation, with real interest rates rising, does cash become more attractive. If nominal rates are repressed, higher inflation would actually result in even lower real rates, making cash a particularly bad investment. In this scenario, purchasing power is eroded and real assets are a more effective way to preserve value.
What is the likelihood that inflation does not occur in a meaningful way (ex. innovation reduces costs), and how is Nicola positioned for that event?
Rob: Inflation versus deflation is probably the most heavily debated issue in the markets, with strong arguments on both sides. A severe deflationary outcome would be particularly hard on asset returns, but a diversified portfolio of quality cash-flowing assets should provide the best protection.
If inflation is an increasing factor that investors need to consider, how do we see this impacting returns on precious metals?
Rob: It depends on what nominal interest rates do. If nominal rates move higher with inflation or even more than inflation, the attractiveness of gold will be diminished. Gold performs best when real interest rates are low and getting lower as this indicates purchasing power is being eroded and real assets like gold become more attractive. If real rates are positive, the attractiveness of non-income-producing assets like gold is reduced.
John, are you still invested in preferred shares?
John: I am. Having said that, a strong recovery of almost 60% over the last year has occurred and as such yields have dropped from about 8% to 4% today. That is still a good fixed income return given the favourable tax treatment preferred share dividends receive in taxable portfolios. Because we are strong believers in disciplined rebalancing, our preferred share position will now reduce, but we will still maintain a position.
What investment would you recommend to get a 10% return over the next 12 months? And how much associated risk?
John: We generally do not speculate on returns going forward and certainly not for periods as short as one year. There are asset classes we believe will get good risk-adjusted returns over the next five years as we presented in the Strategic Outlook event. They include private equity and debt, value-add real estate, and sustainable innovation.
How do you anticipate the gold price and the bitcoin price in 2021?
John: This question reminds me of Sir Isaac Newton’s words after he discovered he has lost 20,000 pounds in his South Sea Bubble investment (close to $4M USD today). “I can predict the movement of heavenly bodies, but not the madness of crowds.”
But as noted above, it does not seem to us an attractive investment strategy for the long term.
What is the best type of fund to invest in for very high-income-earners?
John: We do not think high-income earners should choose significantly different investments than other individuals, but they do need to plan on how they hold those investments to reduce taxes. For some high-income-earners, a higher allocation to less liquid private assets makes sense and can also be more tax-efficient than some publicly traded assets.
Could silver potentially see price appreciation, as it’s used in solar technology?
John: Silver well may perform better for technology reasons. Copper as well.
If work from home expands, do US/China continue to lead globally, or do we see increased growth in foreign markets?
David: With Covid, working from home has already expanded. The question might be, if working from home remains at high levels (versus a rotation back to a physical workplace) what impact will it have on various developed and non-developed economies. Let’s start with work from home in general. Where a business has still been able to operate and has not been shut down from Covid, a number of businesses have thrived during Covid and have seen initial productivity gains with work from home (staff do not have to commute etc). That said, and 1 year on into the pandemic, some of these businesses might be experiencing a slowing or reversing of these productivity gains as overwork and mental health aspects have risen. Developed economies tend to have more professional/white collar (higher paying) occupations that lend themselves to working from home so we would not necessarily see working from home as having a positive or increased growth effect on foreign or less developed markets where a larger proportion of the workforce is in lower-paying factory based occupations that still require the employee to be physically at a work location.
John: I’d recommend a new book by Daniel Yergin called The New Map. He makes a compelling argument that the US and China are effectively a G2 and will dominate the global economy for decades.
When looking at the return of private assets investments how is the valuation determined? Are the private assets appraised annually?
David: Valuations take place much more frequently than annually.
For real estate, we follow a very similar valuation methodology as some of the largest institutional pensions use (both in Canada and globally). For our Nicola Wealth Canadian and US Real Estate pools, each individual property in the pool receives a 3rd party independent valuation on a quarterly basis. In addition, the properties are staggard on their quarterly valuations so that 1/3rd are valued January, 1/3rd February and 1/3rd in March and then the process is repeated such that each property is valued no less than 4 times per year.
For private equity, private debt, mortgages and infrastructure, we also follow best practice and valuation methodologies used by large institutional pensions in these asset classes. Our private equity, private debt and infrastructure pools have their NAV (net asset value) established monthly while our two mortgage pools receive a weekly valuation. The technique used to value investments in each of these asset classes depends on whether our investment in each of these asset classes is held through another GP, is a co-investment or a direct investment.
Are there additional risks in private assets? How does one mitigate that?
David: There are three important risks investors should consider when investing in private assets Liquidity Risk, Investment Minimums and Market Risk.
Liquidity risk is the ease at which investors can get in or out of an investment and certain private investments or private investment structures (such as private equity LPs) can have little to no liquidity for many years. At Nicola Wealth, we mitigate liquidity risk by running open-ended, evergreen, private capital investment pools. The pools hold multiple private assets, invested in and maturing at different time periods and this combination of maturing investments and the timing of new and exiting capital, provides appropriate liquidity for our investors.
With private assets, investment minimums can pose a risk to investors. Often, investing in private assets requires a much larger commitment of investment minimums and these higher minimums for some investors can result in having too much exposure to a single investment which, if the investment fails, can have a detrimental personal financial impact. At Nicola Wealth, we eliminate the risk of high investment minimums for our clients by using our investment pools to meet the high investment minimums of private investments but our investment pools themselves have low investment minimums.
Market Risk generally exists for investors investing in private assets as often private assets are smaller or medium-size businesses that have not matured yet to the size of a large and more stable company. Failure is much more common with smaller companies which can lead to losses for private investment investors. At Nicola Wealth, we mitigate market risk, again by using our open-ended evergreen pools, that lend themselves to diversifying across multiple investments, thereby mitigating the risk and impact of the loss of any single investment.
Will the real estate funds continue to do well over the next 5-10 years given the high real estate valuations and interest rates expected to rise?
David: Interest rates affect the availability of capital and therefore the supply and demand for property and the resulting prices. For example, rising interest rates can make mortgage payments out of reach for certain homeowners, driving them to rent instead. Vacancy rates decrease and rents rise (improving the cash flow for the owner of an apartment rental building). In turn, demand for investment rental properties increases, the supply of this real estate sub-asset class decreases, making this real estate sub-asset class scarcer and perhaps positively impacting its value. The reverse is also true, if investment real-estate is over-leveraged by owners and the mortgages on those properties mature into a high-interest rate environment and the owner is unable to adjust rents and cash flow, then the result can be a negative impact on price and valuation.
For the past 20 years, just about every asset class, from public equities, the bond market and real estate, have benefited from falling interest rates. It is not just real estate that has high valuations. North American stock market indexes are also at all-time highs. One of the strengths of investing in income-producing real estate is the relatively higher amount of cash flow it generates versus other equity investments. If valuations are high and price appreciation is harder to achieve, then generating a return from cash flow becomes even more important.
Lastly, given the above, and over the next 5 to 10 years, we believe that a well-balanced portfolio means having a healthy allocation to investment grade income-producing real estate. For us, this also means focusing on certain real estate sub-asset classes, in certain geographic locations, combined with adding value by repositioning or developing real estate assets, should enable us and our clients to achieve consistent and stable returns.
When do you expect the new capital gains rates in the US to come into effect?
John: The bill to raise taxes on capital gains to about 40% for those earning more than $1M of personal income is now before Congress. The intent is to make the new rates effective in 2021. There is already fierce resistance from Republicans so it is hard to know what compromises may emerge.
Is it prudent to sell a capital asset today thinking that the Capital Gains inclusion rate goes up? Or is it best to do an asset freeze?
John: Generally, we are not in favour of triggering a sale of assets based on future tax changes that may not occur. The exception might be for assets that you are considering selling in the near to medium term. An asset freeze is a good tool to use to defer capital gains on assets you plan on transferring to your children or grandchildren. Technical issues related to that are too numerous to deal with here, but your advisor can help work with you to see if this is a viable option.
Do you think the recent news regarding capital gains taxation in the US makes it more likely we’ll see an increase in Canada?
John: If Biden’s tax bill passes in the US, then I would not be surprised to see higher capital gains taxes in Canada.
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. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. This investment is generally intended for tax residents of Canada who are accredited, investors. Some residency restrictions may apply. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.