Weaker Dollar, Better Return


Highlights This Month

The NWM Portfolio

Investment returns would suggest it was a risk-on month in January, but it sure didn’t feel that way.  Volatility increased and non-domestic security returns benefited from a weak Canadian dollar.

As interest rates moved sharply lower, bond prices moved higher with 2-year Canada yields ending the month at 0.95% versus 1.14% at the start of the month.  10-year Canada’s rallied even more, ending the month at 2.34% versus 2.76% on December 31.

NWM Bond was up 0.8% in January, benefiting from the decline in interest rates, but restrained by the short duration strategy employed in the fund.  Over the long term, we believe interest rates will need to normalize and move higher.  It just didn’t happen last week.  Investors were looking to reduce risk and bonds were a good place to hide.

Credit spreads continued to provide positive returns in January, as NWM High Yield Bond increased 2.2%. Lower interest rates certainly helped returns, but even our long/short manager gained nearly 1%.

Global bonds were also higher, with NWM Global Bond increasing 2.2%.  Again, the weak Canadian dollar was a positive contributor to these results.

NWM Alternative Strategies had a solid month in January, increasing approximately 3.11% and continues to do its job, providing uncorrelated returns.

And finally, gold is performing again, too.  After falling nearly 23% last year, bullion was up 8.5% (in CAD) in January.  Gold stocks did even better, with NWM Precious Metals increasing 15.6%.  3 cheers for diversification!

The REIT market was stronger in January with NWM Real Estate up 0.5%.  Mortgage returns were steady as always, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.6% and 0.5% respectively for January.

NWM Preferred Share returned 0.74% for the month of January, in-line with the overall markets as the S&P/TSX Canadian Preferred Share Index ETF returned 0.76% and the BMO Laddered Preferred ETF returned 0.74%.

We repositioned our portfolio last month by selling some short duration rate resets, thus allowing us to participate in the recovery as bond yields provided a boost to the overall market with the 10-year Government of Canada falling 42 bps to 2.34%.

The big news driver in the preferred space was the launch of the NVCC Royal Bank, National Bank, and Canadian Western Bank issues. All three issuers released contingent convertible shares (“cocos”) which allow regulators to convert the securities into equity if the bank gets into financial distress.

The shares were greeted favorably by the market with all of them upsized and NWM Preferred Share investing in the Royal Bank issue. We believe that more cocos will be brought to the market and should provide attractive investment opportunities in the future.

Canadian equities were mixed in January with the S&P/TSX gaining 0.8% (total return, including dividends), while NWM Strategic Income was down 0.1% and NWM Canadian Tactical High Income was up 0.1%.

Lots of trading to start the year.  In the Strategic Income pool, we were called away on our IMAX position and chose to use the proceeds to establish a position in Element, a leasing company.  We were also called away on part of our Silver Wheaton and Thomson Reuters position.

Along with the proceeds from the partial sale of our position in Gluskin Sheff, we established new positions in grocery chains Empire and Weston, as well as asset manager, Guardian Capital.  We further trimmed Thomson Reuters, as well as Cenovus and Ag Growth, and established positions in CGI Group and ATS Automation.

The cash position is currently about 3.5% and approximately 7% of our Canadian positions are covered and just under 1% of our U.S. holdings. With the Canadian Tactical High Income pool, we added two new naked puts (Weston and Empire) and re-wrote options on nine existing positions.  We also trimmed our position in Gluskin Sheff.

Foreign equities were mainly stronger in January with NWM Global Equity up 1.1% versus 0.7% for the MSCI All World index, and 0.9% for the S&P 500 (all in Canadian dollars).  All our external managers were up in January led by Edgepoint +2.5%, Templeton Smaller Companies +1.1%, Carnegie +0.9%, Cundill +0.4%, and the Guardian Asia Growth and Income Fund +0.3%.

NWM U.S. Tactical High Income returned -3.1% in USD (approx. 1.5% CAD).  We re-wrote 19 options (4 covered calls and 15 naked puts), fully covering Newmont, Kinder Morgan, and Royal Dutch.

January in Review

By Rob Edel, CFA

After such a great year for equity returns in 2013, and a bull market that has run in excess of 60 months, investors could be excused for fearing a pullback in the market.

Such fears can be self-fulfilling, however, and global equities didn’t disappoint in January with the S&P 500 falling 3.5%.

Only a weak Canadian dollar saved investors venturing outside our borders as a 4.8% decline in the loonie versus the greenback meant S&P 500 losses in Canadian dollar terms were a positive .9%.

The same goes for other global exchanges. European stocks (as measured by the Stoxx Europe 600) lost 1.6% in euros, but were up 0.7% in Canadian dollar terms. In Asia, the Shanghai Composite lost 3.9% and the Nikkei 225 declined 8.4%, but to Canadian investors, Chinese stocks were up 0.8%, while losses in Japan were held to just -1.8%.

In fact, the weak Canadian dollar overshadowed what would have been a strong relative market for Canadian equities, with the S&P/TSX index gaining 0.8% – much stronger than global equity returns measured in their local currencies, but about average when global returns are translated back into Canadian dollars.

While equities were headed lower, bonds were back in demand, with 10-year Canada yields rallying 0.4% (lower yield means higher prices) and credit spreads widening. Many investors hailed this market action as a return of RO-RO markets – or risk on, risk off – with risk off ruling in January.

Gold, possibly the ultimate risk-off asset, also benefited from the decline in rates and defensive action taken by traders and was a major contributor to the S&P/TSX index’s superior relative performance in January.

MMC-2014-01-Taking a Breath

So what caused traders to flip the risk-off switch in early 2014 (other than just believing a correction was overdue, of course)?

Well, as always, there is a plethora of things to worry about, but we would highlight the following: a string of poor economic numbers in the U.S., the Feds continued move towards tapering, a slowing Chinese economy, and turmoil in a number of emerging market economies.

MMC-2014-01-Unfolding Events

The U.S. Economy

December and January’s U.S. job reports were disappointing. After four months of average job growth in excess of 200,000, an anemic 74,000 jobs were created in December and was promptly followed by a very uninspiring 113,000 new jobs in January.

While weather might have slowed hiring in December, the Labor Department reported weather in January was consistent with historical trends, namely it was cold and snowy. Backing up Labor Department’s view, the construction sector, which one would expect to be impacted the most by weather, added 48,000 jobs in January after shedding 22,000 in December.

It wasn’t all bad news, however. Private payrolls continue to fare better and wage inflation moved marginally higher in January.

The unemployment rate moved down to 6.6% from 6.7% in December, and the participation rate (the share of Americans of working age actually working or looking for work) moved up slightly to 63% from 62.8%.

Not time to panic yet, but we’ll need to see more from the job market over the next few months.

MMC-2014-01-Wintry Mix

In addition to disappointing job growth, the housing market, a bright spot in 2013, continued to decelerate. Prices remain strong and inventories low, but sales are trending lower, with an 8.7% decline in December pending sales pointing to continued weakness.

The manufacturing industry was also weak with the ISM purchasing managers index in January declining from 57 in December to 51.3, the sharpest drop since May 2011, and lowest level since May 2013.

Even worse, new orders took an even bigger fall, declining a record 13.2 points to 51.2. As disturbing as these drops are, we would point out that both are still above 50 and thus signal manufacturing is expanding in the U.S.

MMC-2014-01-Signs of Weakness

While the polar vortex might not have been the reason job growth floundered in January, it likely was a contributing factor behind the sluggish manufacturing data and poor existing home sales. Auto sales, and consumer spending in general, can be expected to be soft if people are reluctant
to leave their homes.

Also hurting economic growth in January was a decline in exports. An improving balance of trade has been a major driver of GDP growth over the past couple of quarters, and despite the decline last month, we would expect this trend to continue.

The shale oil and gas boom in the U.S. not only means lower demand for imports, but it also provides U.S. industries with cheaper energy and feedstocks.

Like auto sales, while the recent spike in natural gas prices due to colder-than-normal weather might impact short-term results, we expect the impact to be short lived and the manufacturing renaissance in the U.S. to continue to drive economic growth higher.

Also, 2014 could be the year when U.S. companies finally increase capital spending, spurred on by increased global financial stability and stronger domestic demand. Like the domestic auto fleet and housing market, the great recession has resulted in normal purchases and investment being postponed.

A catch up period and return to normalcy will be good for the economy. Despite a string of weak economic numbers, we are still optimistic that the trend for the U.S. economy is positive.

MMC-2014-01-Balancing Act

MMC-2014-01-Ready to Spend

In light of the improving economy, but despite the poor December and January jobs report, the Federal Reserve announced in January a further $10-billion reduction in their monthly bond buying budget, which now will be set at $65-billion in February.

Interestingly, it’s not U.S. markets that have seen the biggest negative impact from tapering, but rather emerging market economies.

When referring to emerging economies, most think of the BRICS, namely Brazil, Russia, India, China and South Africa, but the world has changed a lot since Goldman Sach’s Jim O’Neil first coined the term in 2001. More recently, Fidelity Investments added Mexico, Indonesia, Nigeria and Turkey to the list, referring to them as the MINT countries.

While all of the BRICs and MINTs have come under pressure, it’s a subgroup of these 2 groups that has most investors concerned, namely the Fragile Five, consisting of Indonesia, Turkey, South Africa, India, and Brazil.

MMC-2014-01-Business Insider

This is not an exhaustive list; there are a number of other problem countries, like Argentina and Venezuela, that are in much worse shape, and others, like Russia, where a case could be made for also being fragile.

Nevertheless, the Fragile Five share some common issues that make them vulnerable in a world where central bank easy money policies may be on the wane: all have current account deficits requiring a constant flow of foreign capital.

This is fine when the U.S. Federal Reserve’s quantitative easing program was swamping the global capital markets with liquidity, but with U.S. cash threatening to retreat back to the good old U.S. of A., the Fragile Five currencies and equities have come under intense pressure.

Running low on foreign currency reserves to defend their currencies, Fragile Five central banks have no other choice but to raise rates.

Case in point: India recently raised short-term rates from 0.25% to 8%, South Africa increased rates 0.5%, while Turkey more than doubled the cost of overnight money from 3.5% to 8%.

While such a dramatic move helped stabilize the Lira (and Rand and the Rupee), it won’t help slowing GDP growth, or rising inflation. In fact, increasing interest rates in the face of decelerating domestic economic growth and increasing CPI rates could result in stagflation.

MMC-2014-01-Price Problems

Not all emerging markets are created equal, however, and political problems, especially in Turkey and Argentina, have helped exacerbate the problem.

Unlike in the Asian economy of 1997, most emerging market economies have flexible exchange rates with debt denominated in their own currency. And unlike the Fragile Five, most emerging markets have built up hefty foreign currency reserves, and their current account and budget deficits are quite manageable, especially compared to many developed world countries.

We suspect the current sell off is overdone and expect markets to stabilize over the coming months. However, a lot of money has flowed into emerging economies like the Fragile Five over the past few years as investors have been able to borrow cheap money in counties such as the U.S. and seek higher returns abroad.

If the source of this cheap money is eliminated – and we mean if – money could leave these markets regardless.

MMC-2014-01-Cumulative inflows into EM equities funds and ETFs

The Asian Economy

But what about the granddaddy of all emerging markets – China?

Equity markets were also weak in China, and economic growth is slowing with GDP growth in 2013 coming in at 7.7% versus 7.8% in 2012. And while interest rates are also on the rise, this is where the similarities end.

China has upwards of $3.7 trillion U.S. in foreign currency reserves, more than enough to defend against any currency speculator. This assumes, of course, that traders are even able to bet against the Yuan, as capital in and out of China is tightly controlled. China also has a healthy current account surplus and political problems are dealt with quickly and quietly.

Yes, growth is slowing, but much of this is planned, as Chinese leaders attempt to rebalance the Chinese economy away from exports and infrastructure and more towards a consumption-based economy. Higher interest rates are all part of the process. Oh, and by the way, 7.7% GDP growth is not too shabby.

China’s problem is that economic growth has come at the expense of increasing local government and corporate debt. Standard & Poor’s estimates Chinese companies have accumulated $12.1 trillion in debt, second only to U.S. businesses with $12.9 trillion. Even worse, it’s been growing at a frantic pace.

In 2008, JPMorgan Chase estimated corporate debt-to-GDP in China was 92% compared to 124% at the end of 2012. Comparable emerging market economies typically run corporate debt-to-GDP ratios in the 40% to 70% range, while U.S. corporate debt is about 81% of GDP.

In a recent article in the Financial Times, Ruchir Sharma points out that there have been only five countries that have experienced a credit boom on the same scale as China, and all ended badly.

Sharma believes the increase in private sector debt as a percentage of GDP over the most recent five-year period is the most important predictor in forecasting a future financial crisis, not the absolute size of the debt.

Five years ago, it took just $1 of debt to generate $1 of GDP growth. In 2013, it took almost $4 of debt. Understanding what is truly happening in China is tough; a credit crisis would be very negative for global growth and warrants close scrutiny.

MMC-2014-01-Double Trouble

Interestingly, one of the hardest hit markets in January came from the developed world, namely Japan.

After finishing 2013 as the world’s top performing equity market, the Nikkei reversed course in January and only a poor showing by Brazilian equities prevented Japanese stocks from posting the world’s worst returns.

While Japanese stocks may have moved in sympathy with emerging markets, its currency did not. After falling steadily against the U.S. dollar in 2013, the yen rallied in January, gaining 3.1%. Part of the strength was likely due to the yen and Japanese bonds still being viewed as a safe haven.

Also likely, traders unwound their yen carry trade positions, which involved borrowing cheap Japanese yen and investing in higher-yielding emerging market bonds and stocks. By reversing this trade, investors would need to buy yen, thus driving the currency higher.

A stronger yen is bad for Japanese economic growth as it increases the price of exports. It also works against Prime Minister Abe’s strategy of increasing inflation.

We are still concerned about the longer-term sustainability of the Japanese recovery, but price action in January was more about profit taking and the emerging markets than the Japanese economy.

MMC-2014-01-Currency Correlation

The European Economy

The Japanese yen and the U.S. dollar weren’t the only currencies acting as a safe haven in January; the euro was also strong.

Even when equity markets were falling, the euro managed to strengthen. This is much different than in the past couple of years when traders have used any negative action in the capital markets as an excuse to bail out of the euro.

Helping the euro is the fact that, unlike a lot of emerging market countries, the Euro-Zone has a large and growing current account surplus. In November, in fact, the Euro-Zone current account surplus hit a record €23.5 billion.

Manufacturing is also on the rise, with the purchasing manager’s index for the Euro-Zone in January rising to 52.9, its highest level since June 2011, and well above 50, thus indicating the manufacturing sector is expanding.

Germany led the way with its PMI hitting a 32-month high of 56.5, but many Central European counties also benefited, and Greece’s PMI rose above 50 for the first time since August 2009.

MMC-2014-01-Steadier Ship

But is a stabilizing economy enough for Europe?

Europe is still in deleveraging mode. While Euro-Zone countries have done a good job of reducing budget deficits (combined, the Euro-Zone government deficits in Q3/2013 came in at 3.1%, its lowest level since Q3/2008), absolute debt levels remain dangerously high in peripheral countries like Greece and Italy, where economies are barely growing.

MMC-2014-01-Slackening

Other than defaulting or restructuring, one of the ways to reduce debt is to inflate it away. Unfortunately, inflation in the Euro-Zone fell to a record 0.7% in January. Of course, deflation should not be unexpected in a region where many different economies share the same currency.

Countries like Greece and Italy need to become more competitive compared to countries like Germany. But because they are unable to depreciate their currency, lowering prices and wages is one of the quickest ways to increase their competitive position.

Europe is not out of the woods yet, but the fact that many viewed the euro as a safe haven in January is evidence that many feel the worst is behind the euro-zone.

The Canadian Economy

And what about the most important currency (to us, anyway) of all, the Canadian dollar? While the loonie was a safe haven currency throughout the financial crisis, it has been acting anything but for the last few months.

Economic growth in Canada has slowed at the same time prospects south of the border have brightened.

Like most of the emerging market currencies that were under pressure in January, Canada also runs a current account deficit that has been increasing as our historical trade surplus has turned into steady deficits.

Most forecasters now believe the U.S Federal Reserve will increase rates before the Bank of Canada. Some even believe the Bank of Canada’s next move will be to actually cut rates.

We think this is unlikely, but the Bank of Canada is not going out of their way to convince traders otherwise. A lower loonie is just fine by them, with Bank of Canada Governor Stephen Poloz recently saying the fall in the dollar is simply the “icing on the cake.”

With a lower dollar, the Bank of Canada helps kill two birds with one stone, namely it helps accelerate GDP growth, while also increasing inflation. In their recent Monthly FX Outlook, CIBC recently estimated a 10% decline in the Canadian dollar could add about half a percent to both GDP growth and core CPI.

How much lower could the dollar fall? Last month, we stated a range of 90 to 95 cents would be a good-long term level for the loonie, only to see it promptly trade down through the 90 cent level, so we are a little shy about making any bold predictions.

One U.S. hedge fund manager was recently quoted in the Globe and Mail as saying a 70 cent dollar is possible over the next five years based on continued weakness in emerging markets and an increasing divergence between U.S. and Canadian economic growth.

Throw in a housing market crash and the dollar could fall even more.

We are not so pessimistic.

We still believe a U.S. economic recovery will help Canadian economic growth. Purchasing power parity for the Canadian dollar is estimated at around 85 cents. In terms of Big Macs, the Economist magazine estimates the Canadian dollar is about 5% over valued at present levels.

Based on these measures, there is still room for the dollar to fall further; however, it has already suffered a pretty sharp correction, falling almost 5% in January alone.

The Canadian dollar, in fact, was one of the worst performing currencies in January, despite having one of the best debt-to-GDP ratios in the developed World.

Finance Minister Jim Flaherty, in fact, recently laid out plans in his new budget that would deliver a budget surplus for Canada in 2015. The dollar could trade lower over the next few months, but we still like the 90 to 95 cent range.

We hope by saying this, we haven’t doomed the dollar to correcting more.

MMC-2014-01-Loonie Tunes

As for the Canadian economy, unlike the U.S., employment growth rebounded in January with 29,400 net new jobs created. The unemployment rate declined to 7.0% from 7.2% in December and wage growth increased to 2.6%.

Everyone is watching the housing market, expecting it to crash, but so far it remains stable with prices and sales remain firm. New construction should moderate, but only a spike in interest rates or sharp deterioration in the job market would likely result in a crash.

For Canada, improved economic growth should become evident in a declining trade deficit. According to Bloomberg, about a third of Canada’s economy is derived from exports, of which 75% ends up going to the U.S.

We believe Canada’s trade deficit should decline in 2014 as the U.S. economic recovery gains traction.

Let us know your thoughts on December’s market activity in the comments below!

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. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. NWM fund returns are quoted net of fund level fees and expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value.