By Rob Edel, CFA
Highlights This Month
- Where we stand.
- October’s pre-election markets saw bonds and equities fall.
- Markets rally after Trump victory, for now.
- Pro-growth = more government spending, efficient monetary policy, and higher interest rates.
- Inflation in the “Trump Era”: what can we expect.
- Trump’s initiatives could drive interests rates higher.
- Trump is in but now comes the real work.
- What we are really looking at.
The NWM Portfolio
Returns for NWM Core Portfolio Fund increased 0.9% for the month of October. NWM Core Portfolio Fund 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.
Short term interest rates in both Canada and the U.S. increased in October with the yield curve steepening. While higher interest rates are bad for bond returns, falling credit spreads can help offset the losses. As such, NWM Bond Fund was up 0.2% with strong performance from Arrow East Coast +1.5% and Marret High Grade Hedged Fund +0.8%.
Falling credit spreads also has a positive impact on NWM High Yield Bond Fund, which returned +2.5% in October. Positive movements in foreign currency helped global bond returns last month, with NWM Global Bond Fund up 2.9%.
NWM mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage Fund and NWM Balanced Mortgage Fund returning +0.3 and +0.4% respectively in October. 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 in no way is a predictor of future performance, are 4.2% for NWM Primary Mortgage Fund and 5.3% for NWM Balanced Mortgage Fund. NWM Primary Mortgage Fund ended the month with cash of $22.1 million, or 13.9%. NWM Balanced Mortgage Fund ended the month with $69.9 million in cash, or 15.6%.
NWM Preferred Share Fund was up for the month of October returning 2.7% while the BMO Laddered Preferred Share Index ETF returned 3.4%. In a relatively benign investment grade corporate market, interest rate yields moved materially higher in the first part of October before 5-year Government of Canada’s settled around 0.70%.
Although the trend is quite noisy amongst elevated volatility, rates have been steadily moving higher since June. The sharp move higher in yields helped create a strong bid for low rate resets, a part of the market we have been underweight in. We are continuing to selectively look for opportunities in this segment of the market as tax-loss selling at the end of the year may provide attractive opportunities despite the increased volatility of these issues.
Canadian equities were positive in October, with the S&P/TSX +0.6% (total return, including dividends), while NWM Canadian Equity Income Fund and NWM Canadian Tactical High Income Fund were up 1.2% and 0.4% respectively. The financial sector was strong last month as a steepening yield curve and higher interest rates are good for banks and insurance companies. Energy was up 13.5% mid-month but finished the month only +1.9%.
In the NWM Canadian Equity Income Fund, we sold our positions in Crescent Point and Agrium, and initiated a position in DH Corporation. We also trimmed our positions in Enbridge and Methanex and added to existing positions in Suncor, TransCanada and Whitecap Resources. In the NWM Canadian Tactical High Income Fund, additional puts and calls were written on existing positions, but no new names were added to the portfolio. We were called away on our Bank of Nova Scotia position and we trimmed KP Tissue.
Foreign equities were weaker in October with NWM Global Equity Fund down 1.0% compared to a 0.2% increase in the MSCI All World Index and a 0.3% rise in the S&P 500 (all in Canadian dollar terms). All our external managers produced negative returns with Pier 21 Carnegie -0.2%, Edgepoint -0.8%, Lazard Global -1.2%, BMO Asia Growth & Income -1.4%, and Pier 21 Value Invest -2.0%%. NWM U.S. Equity Income Fund decreased 1.6% in U.S. dollar terms and NWM U.S. Tactical High Income Fund increased 0.2% versus a 1.8% decline in the S&P 500 (all in U.S. dollar terms). In NWM U.S. Equity Income Fund, we established a position in L-3 Communications and sold General Electric and Ford. As for the NWM U.S. Tactical High Income Fund, we added a new short-put position in Becton Dickinson.
Real estate increased in October with NWM Real Estate Fund up 1.0% versus the iShare REIT Index down 2.4%.
NWM Alternative Strategies Fund was up 1.4% in October (these are estimates and can’t be confirmed until later in the month). Of our Altegris feeder funds, Winton was flat for the month, but Brevan Howard, Millenium and Citadel were up 2.6%, 2.3% and 4.0% respectively. All our other alternative managers were up as well with MAM Global Absolute Return Private Pool +0.7%, RP Debt Opportunities +1.1%, Polar North Pole Multi-Strategy +0.4%, and RBC Multi-Strategy Trust +1.0%. Precious metals were weak in October with NWM Precious Metals Fund-4.0% and gold bullion down 0.9% in Canadian dollar terms.
October in Review
We were in the midst of writing our monthly re-cap for October, and then the results for the U.S. election came in and our attention, and priorities, changed from what happened last month to what was happening right now and how it will impact our outlook over the coming months.
In fairness, some of the market action we saw last month was due to the increased odds of a Trump victory, so we still believe it is worth reviewing, but overall markets were caught off guard with some forecasters giving Trump only a 1% chance of winning just before the polls closed on November 8th. I know, given the Brexit result, markets should have seen it coming. Fool us once, shame on you. Fool us twice……well you know the rest. Not only did Trump handily assemble the 270 electoral votes required to claim the Presidency, but the Republican Party retained control of both the House of Representatives and the Senate.
Most pre-election conversations centered on the potential implications of a Democratic sweep. Not many strategists spent much time detailing what a Republican sweep would look like. Not since George W. Bush was President in 2003-2007 have Republicans controlled all three branches of government, giving them an opportunity to pass legislation and make real changes, good or bad.
There are, of course, many questions that remain to be answered, like, who is Donald Trump really? What does he believe in versus what he felt he needed to say and do to get elected? Perhaps even more importantly, who is he going to appoint to his cabinet? Because he needs some experienced help.
Our first look at what a Trump presidency will look like will be based on who he chooses to surround himself with. His inner circle needs to broaden beyond the group advising him during the campaign and include people that were not necessarily supporters. Even though Trump ran as a Republican, he hasn’t been a devout Republican, nor has he traditional Republican views in the past.
He owes nothing to the traditional Republican power base as they didn’t support him and largely had nothing to do with his victory. It is far from a foregone conclusion the Republican sweep will result in Republican unity and action. Bottom line, uncertainty is likely the only certainty.
Case in point, the market sold off overseas as it looked like Trump was headed towards victory. Dow futures were off 900 points, or 4%, gold was up $25 an ounce, and U.S. treasuries were rallying, with yields headed lower. The next day, however, after the results were official, the Dow surged 250 points, gold was flat, and 10-year U.S. treasury yields were up 20 basis points to 2.05%; from panic to euphoria in a manner of hours.
The rally is even more impressive given the market was up the two days previous in anticipation of a Clinton victory! Not only were stocks able to hold onto these gains, but they moved even higher. Trump aside, perhaps the market confusion is warranted given different historical perspectives the street appears to have. One source we read noted the combination of a Republican President and Congress has historically (1933 to 2015, but excluding 2001-02) delivered the highest subsequent annual S&P 500 returns; while another claimed the time period 1928 to 2014 saw a Republican sweep deliver the weakest market returns.
Before looking more closely at the implications of the U.S. election for global markets, let’s quickly recap what happened in October, which was generally a tough month for equity investors. Canadian stocks were up, with the S&P/TSX increasing 0.6%, but U.S. stocks were weak with the S&P 500 recording its worst month since January, down 1.8%. The Dow Jones Industrial Average fell for the third consecutive month, its longest losing streak since 2011, and the NASDAQ fell for the first time in four months. Trader angst was evident in the lower than normal trading volume for much of the month, with investors staying mainly on the sidelines.
According to the American Association of Individual Investors, only 25% of retail investors are bullish; the tenth consecutive week this measure has remained below 30% and the 51st straight month the survey has been below its long term average. The S&P 500, in fact, fell for nine consecutive trading sessions at the end of October and into early November, its longest losing streak since 1980.
Investors didn’t get any relief from the bond market either. After falling for most of the year, bond yields were on the rise last month, with U.S. 10-year government bond yields back to levels last seen in May. German 10-year bund yields also increased, moving back into positive territory, and even UK gilt yields moved higher. So why were equities and bonds under pressure last month? Donald Trump and inflation.
While Hilary Clinton may have been the second most unpopular presidential candidate since Barry Goldwater, Donald Trump took top spot. With Clinton’s email problems resurfacing in the closing days of the campaign, the prospect of a Trump victory increased, and while it was always perceived to be a long shot, the markets reacted negatively. Only after the FBI announced no charges would be recommended against Clinton, did the markets rally with the S&P 500 up over 2% the Monday before the election.
Clinton may be unpopular and untrustworthy, but she is more of a known entity. Just the prospect of a Trump presidency increased uncertainty in the markets and the economy.
Yes, we know, if this is true, why did the markets rally after he was actually elected? First, by the time you read this commentary the markets could have reversed and turned lower. Uncertainty and volatility is the one scenario we feel most confident in forecasting, and just because the markets rallied the day after the election, doesn’t mean they will keep going higher.
Historically, however, uncertainty peaks before an election and subsides after as policies become clearer. Companies like Starbucks and Dunkin’ Donuts, in fact, blame the election for weaker sales. We’re somewhat skeptical Americans cut back on their doughnut consumption because of the election, but businesses certainly were more cautious in their outlook. Specific sectors, like healthcare, were also under pressure having been frequently targeted by democratic candidates during the campaign. An old market adage reminds investors to “buy the rumor, sell the news,” meaning traders take positions based on how they believe markets will respond to particular news, only to reverse course once the facts are known. Trump is going to be President; that is now a fact.
Second, Trump is seen as a pro-growth candidate. He has promised to lower taxes, invest in massive infrastructure projects, scrap unnecessary regulations, and adopt a protectionist trade policy. This is largely why the bond market sold off. More government spending and stronger economic growth means monetary policy will normalize faster and interest rates are going to move higher. Already corporate earnings looked to have bottomed, with third quarter profits increasing after four consecutive quarters in the red.
What about inflation? Even before Trump’s victory, higher wages and energy prices were starting to finally push prices higher. The maker of Swiss chocolate bar Toblerone, for example, has recently announced they are reconfiguring their bars with narrower triangles and larger gaps between peaks. Prices won’t change, but the bars will contain less chocolate. It’s when inflation starts to really hit home when consumers start to notice!
If Trump is able to make good on even some of his campaign promises, inflation could go even higher. Reduced immigration will result in even higher wages, as would tighter trade restrictions with Americans paying more for domestically produced goods. While he has not always been consistent on the subject, Trump has generally lobbied for higher interest rates, criticizing the Federal Reserve and Janet Yellen for keeping rate too low for too long. We are not going to suggest the Fed will bow to political pressure, but it makes it even more likely Yellen will be replaced as Chairperson when her term is up in 2018, if she resists. We actually think she would like to see rates higher as well, so increasing interest rates is the path of least resistance.
It’s not all clear sailing for the Donald, however. Repealing Obamacare (The Affordable Care Act) will be the first order of business for Trump and the Republicans. This should be easy given both Trump and the Republican-controlled Congress agrees the ACA is “a disaster.” Of course, what to do with 20 million Americans that will now be without health insurance is another issue.
Lowering taxes should also be an easy layup. House leader Paul Ryan will be more than happy to put together a plan for Trump that will include corporate tax reform and potentially lead to billions of corporate dollars stranded in foreign subsidiaries finding its way back to America.
What’s more Republican than lowering taxes? Somewhere, the Gipper must be smiling. It’s an easy win, and frankly should have happened a long time ago. After that, however, things start to get a little tougher.
Not all Republicans share the Donald’s affinity for debt. Some even feel the U.S. already has too much debt and would like to see it decline rather than increase. If interest rates continue to move higher, servicing the debt will become much harder. All this becomes manageable if Trump’s policies generate sustainable economic growth. As long as GDP grows faster than debt, it’s all good. But what if the infrastructure spending is deployed into unproductive partisan projects? How much will the economy grow if the tax cuts mainly benefit the upper class, and not the middle class?
If all Trump does is end up with the same slow-growth economy, but with more debt to service and higher interest rates, America will be far from great again. This is the risk with Trump. The market may give him the benefit of the doubt in the short term, but will be quick to turn on him if growth doesn’t kick in.
What about Canada, you ask? Hopefully, Trump should be good for Canada. Yes, Trump has talked about changing NAFTA, but he is really targeting Mexico. The energy sector should benefit as Trump is not a big believer in global warming, or the environment.
The Canadian dollar is under pressure, but more because of the prospect of the interest rate differential between Canada and the U.S. rising. We are concerned about consumer debt levels, however. Higher interest rates would hit overleveraged Canadians hard. The housing market has provided the Canadian economy with needed support over the past few years but it is likely to start reverting to the mean and higher interest rates could be the catalyst.
In Europe, the economy looks to be slowly improving. Industrial production came in higher than expected in the third quarter while unemployment and productivity continue to trend in the right direction. As in the U.S., interest rates have begun to normalize with German 10-year yields back into positive territory.
The biggest concern with the Eurozone over the next year is political. Italy has a referendum coming up in November and both France and Germany have general elections in 2017. After Brexit and now the U.S. election, how big a surprise would it be for populist candidates to gain traction? I mean, as we pointed out earlier, we have already been fooled twice. The polls have the odds of a no vote in the Italian referendum at about 50% which, based on past performance, would mean it has no chance of passing. What if German voters say auf wiedersehen to Chancellor Angela Merkel?
Europe isn’t our biggest concern. China remains the biggest risk for global markets. Corporate and consumer debt in the middle kingdom continues to expand at record levels while economic growth slows. At the same time, a stronger U.S. dollar is putting pressure on the Yuan and capital continues to look for an exit, with China’s foreign currency reserves falling $45.7 billion in October to $3.12 trillion.
The fact Trump, who has branded China as a currency manipulator in the past, has promised to take a “tough line” on U.S./China trade should worry Chinese leaders. Trump may talk about NAFTA being a bad deal for America and its true imports from Mexico have increased dramatically since tariffs between the two countries were lowered, but U.S. content makes up about 35% of all Mexican exports compared to only 3% for China. Mexico is very much an integrated component of the U.S. supply, while China is taking its supply chain in house. As a result, U.S. exports to China fell 14% and the U.S.’s trade deficit with China hit a record last year.
From a geopolitical perspective, however, the Donald becoming president could be seen as a great victory for China. Hilary Clinton was characterized as a much tougher and experienced opponent than Trump, who might be easier to manipulate. Already, Trump has indicated less resolve in backing America’s traditional allies in the Pacific, which could result in more countries falling under the influence of China in the region.
China may also feel it has scored an ideological victory over democracy as a result of the outcome of the election. In China, leaders are not elected by the people, but are carefully groomed by the party. The fact, in their view anyways, that an unexperienced billionaire reality show star can become the leader of the strongest country in the free world confirms to the Chinese that democracy might not be everything it’s cracked up to be. Trump’s blasting of the media throughout the campaign also gives credence to Chinese claims that the Western media is biased.
How President-elect Trump deals with China is but one of many uncertainties facing the market over the next few months. A Hilary Clinton victory was mainly seen as extension of the last eight years of the Obama presidency, which is likely one of the reasons she lost. President Obama’s original campaign slogan was “Change you can believe in.” Whether you believe it or not, Trump will make changes. Whether he will be able to “make America great again” is another thing.
Key for us in the short term will be interest rates. If they move up too quickly, the economy and markets could turn lower before Trump is even able to take office. More likely, we would expect volatility to increase, but yields and equity markets to remain range-bound until more clarity is given in regards to what Trump is and isn’t able to do. At least Alex Baldwin will be happy. Trump’s victory just secured him 4 years of steady work on Saturday Night Live.
What did you think of October’s economic activity? Let us know 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.