By Rob Edel, CFA
Highlights This Month
- Is it time to take cover, or buy the dips?
- Tighter monetary conditions may cause the next recession.
- Black swans, elephants, and gray rhinos, oh my!
- North Korea vs. Trump: the face-off we’ve seen before.
- The U.S. economy: not showing its cards.
- The Eurozone sees growth for 17 straight quarters.
- Is the Canadian housing market a predator in the weeds?
- What all the wild animals have in common – a debt problem.
- Steady economic waters should keep interest rates down.
- Diversification: the survival strategy.
The NWM Portfolio
Returns for the NWM Core Portfolio Fund were up 0.5% for the month of August. We estimate that this fund has a U.S. dollar currency exposure of 36%. The 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.
The Canadian yield curve flattened last month, with 2-year Canada’s declining 0.04% and 10-year Canada’s -0.21%. U.S. yields followed a similar flattening pattern, with 2-year treasuries declining 0.02% and 10-year treasuries -0.18%. For the month, the NWM Bond Fund was flat, though we suspect timing might explain some of the shortfall in performance. Given the decline in rates in August and absent a backup in credit spreads, returns in the NWM Bond Fund should be positive.
The NWM High Yield Bond Fund had flat monthly returns during a quiet August. The high yield market weakened over one percent for most of the month but rallied back to even in the final week. Although high yield credit spreads remain tight on average, there has been increasing dispersion among sectors and issuers. Credit spreads have widened for some fundamentally challenged high yield sectors, including retail, pharmaceuticals, and media. In investment grade, by contrast, general macroeconomic factors continue to positively influence market flows broadly, keeping a tight range of credit spreads across industry sectors.
Global bond returns were stronger last month, with the NWM Global Bond Fund returning 0.6%.
The NWM mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.3% and 0.4% 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 in no way is a predictor of future performance), are 4.2% for the NWM Primary Mortgage Fund and 5.4% for the NWM Balanced Mortgage Fund. The Primary ended the month with cash of $14.1 million, or 8.4%. The Balanced ended the month with $54.5 million in cash or 10.9%.
The NWM Preferred Share Fund returned -1.0% for the month of August while the BMO Laddered Preferred Share Index ETF returned -0.8%. The weakness in the market was not surprising given credit spreads widened 10 basis points while 5-year Government of Canada bond yields fell 12 bps to 1.53%. Enbridge, one of the largest preferred share issuers, led prices lower as thin trading volume highlighted a slightly disappointing quarter. Capital Power, Intact Financial and Kinder Morgan all came to market during the month; however, we did not participate in any of the deals given their structure and pricing.
Canadian equities were stronger in August, with S&P/TSX +0.70% (total return, including dividends). The NWM Canadian Equity Income Fund returned +0.8%, despite having no exposure to the gold sector. The NWM Canadian Tactical High Income Fund was flat in August. The fund still maintains a low net equity exposure (current delta adjusted exposure is 42%). We added a position in Sleep Country with the proceeds from the sale of Great Canadian Gaming in the NWM Canadian Equity Income Fund, while the NWM Canadian Tactical High Income Fund wrote new naked put positions on Cineplex.
Foreign equities were also higher last month, with the NWM Global Equity Fund up 0.5% compared to a 0.9% decline in the MSCI All World Index and a 0.3% increase in the S&P 500 (all in Canadian dollar terms). Results for our external managers were mixed last month, with Pier 21 Carnegie and Edgepoint both up 1.9% and Lazard Global +0.1%. BMO Asia Growth & Income was down 0.2% while Pier 21 Value Invest was -1.2%. Our new internal Europe Australasia & Far East (EAFE) quantitative investments returned +0.2%.
NWM U.S. Equity Income Fund increased 0.4% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 0.3% versus a 0.3% increase in the S&P 500 (all in U.S. dollar terms). In the NWM U.S. Equity Income Fund, we initiated a position in Nextera Energy and sold GGP Inc., Anadarko Petroleum, United Technologies, and Synchrony Financial. As for the NWM U.S. Tactical High Income Fund, we added a new naked put position in Apple. The net equity exposure (delta) in the NWM U.S. Tactical High Income Fund is only 26%.
In real estate, NWM Real Estate Fund was down 0.01% versus the iShares REIT Index +1.3%. Our internal hard asset real estate limited partnerships are priced with a one-month lag. July’s performance for SPIRE Real Estate LP was +1.0%, SPIRE U.S. LP +0.3%, and SPIRE Value Add LP +0.7%.
The NWM Alternative Strategies Fund was up 1.2% in August (these are estimates and can’t be confirmed until later in the month) with Winton +2.4%, Citadel +2.0%, Millenium +1.4%, and Brevan Howard was flat. We have almost completed the final redemptions from Brevan Howard. Of our other alternative managers, all have positive performance with the exception of RP Debt Opportunities, which was -0.1%. Polar North Pole Multi-Strategy was +0.4% and RBC Multi-Strategy Trust +0.5%.
Precious metals stocks were stronger last month with the NWM Precious Metals Fund +10.4% while gold bullion up 4.1% in Canadian dollar terms.
August In Review
August is traditionally a tricky month for the markets. Trading volume is typically low, with many traders taking holidays and performance tends to be poor. According to Bespoke Investment Group, the S&P 500 has averaged a 1.4% decline in August over the past two decades, and since 1945 only September’s 0.7% loss was worse than the 0.2% haircut investors endured in August.
In fact, the second-worst decline ever in the S&P 500 took place August 1998, when stocks fell almost 15% in just four weeks. That kind of volatility has been virtually non-existent of late, however. LPL Financial recently pointed out the S&P 500 hasn’t experienced a 5% decline since June 28, 2016, the fourth longest time period the market avoided a decline of this magnitude. Currently, it’s been at least nine months since even a 3% decline.
Markets have been eerily quiet. During the three weeks prior to the market’s 1.5% decline on August 10th, the S&P 500 experienced a daily price swing of no more than 0.3%, the first time in the history of the S&P 500. Year to date, the average daily trading range has been only 0.55%, also a record, while the Dow has been even more subdued. The Dow has been averaging no more than a 0.3% move in either direction, its lowest daily swing in 53 years.
The drama on August 10th, which also saw the Chicago Board Operations Exchange (CBOE)’s Volatility Index (VIX) spike 5 points higher, was short lived and the market recovered nearly all its losses over the following three days before suffering another 1.5% correction on August 17th. For the month, however, returns were uneventful, with the S&P/TSX up 0.7% and the S&P 500 +0.3% in U.S. dollar terms. So what do investors do, take cover or buy the dips?
There are lots of reasons to be fearful of this market, but it being August or September is not near the top of our list. Neither is the duration of the present bull market, which at over 101 months and counting is the second longest in history. Many dispute the bull market’s age anyway, arguing the two 10 percent corrections the S&P 500 experienced in 2015, in which more than half the companies in the S&P 500 fell more than 20%, constitutes a bear market; similar to the market action experienced in 2011 (when the market also narrowly avoided an official bear market).
Even now the breadth of the market is not great, with more S&P 500 stocks hitting 52-week lows than after Brexit or post-U.S. presidential election. Yes, the market is not cheap, but it’s hardly been a market of speculative excess. Economic recessions caused by tighter monetary conditions are usually behind most bear markets, and we suspect they will be the cause of the next one as well, whenever that may be.
Because the health of the global economy is so pivotal to the future of the capital markets, one can’t have a discussion about asset allocation without checking on where we are at in regards to the current economic cycle, so we will. We also, however, need to keep an eye on the so-called black swan events.
First theorized by financial professional turned author Nassim Taleb, black swan events refer to unexpected and impossible-to-predict events of large magnitude and consequence. The demise of hedge fund Long Term Credit is a classic example, but many also include the 2008 financial crisis as a Black Swan event. Black swans are supposed to be impossible to predict, however as Michael Lewis’ book (and subsequent movie) “The Big Short” shows, some traders were quite capable of predicting the housing bubble and subsequent financial crisis, making buckets of money in the process. Some potential Black Swans are in fact very visible to some but ignored by most.
In Michele Wucker’s recent book, The Gray Rhino – How to recognize and act on the obvious dangers we ignore,” Wucker builds on the idea of Black Swans and the proverbial elephant in the room to describe future events that are highly visible, arguably very probable, but yet are ignored or neglected. Weighing upwards of a ton, a gray rhino is very visible and hard to miss but can be easily ignored until it decides to charge and causes severe damage or physical harm. Call them black swans, elephants in the room, or gray rhinos, we believe it is important for investors to keep a watchful eye on some perhaps not so hidden dangers. After all, it’s a jungle out there.
The volatility we saw last month was due mainly to North Korea and Donald Trump. North Korea’s threat to fire four missiles towards Guam and the Donald’s “fire and fury like the world has never seen” response, appeared to put the two countries on a collision course to nuclear war. Not to downplay the threat, but the market has seen this movie before and the ending is fairly predictable.
Since 1993, there has been very little connection between the market and the 80 documented international incidents involving North Korea. The S&P 500 fell an average 0.4% the day after North Korea conducted one of their 36 nuclear or missile tests. However, half of this was due to one of the missile tests occurring at the same time as Russia’s debt default crisis, which skewed the average higher.
Markets were also weak after President Trump failed to condemn neo-Nazi groups after protests in Charlottesville, Virginia turned violent. This inaction earned the Donald praise from former Ku Klux Klan leader David Duke, but condemnation from pretty much everyone else.
Traditional safe-haven investments, gold, U.S. Treasury bond prices, and the Japanese Yen all rallied last month. Interestingly, the U.S. dollar, which has historically also been a safe haven investment, continued to decline. While this could be due to investors losing confidence in the Trump Administration, we believe it to be more a reflection of the market’s expectation on the future direction of U.S. interest rates. This is what will really drive the direction of the market. The rest is just noise.
Bull markets typically end when a central bank tightens monetary policy in reaction to an overheating economy and the subsequent increase in interest rates starts to slow economic growth. So far, there are no signs of either a recession or an overheating economy. Declining bank loans are the only real negative indicator we have seen for the U.S. economy. Consumer confidence remains strong and second quarter GDP growth was revised higher last month to 3%, the highest quarterly growth rate for the U.S. since the first quarter of 2015, but hardly a sign the economy is overheating.
In addition, global growth also looks solid. For the time since 2007, all 45 Organization for Economic Co-operation and Development (OECD) economies are on track to show growth this year, with 33 countries expected to show accelerating growth. Manufacturing looks healthy, with most developed and emerging market economies experiencing an expanding manufacturing sector and industrial metal prices have continued to rally.
Inflation is the key variable to watch when it comes to determining the intentions of the U.S. Federal Reserve in regards to monetary policy. The current unemployment rate has moved below its long-term average, but wage growth and inflation, in general, has remained subdued.
The Fed has consistently fallen short in forecasting inflation, and falling bond yields are a sign the market doesn’t believe the Federal Reserve will raise rates as aggressively as planned. On August 29th, in fact, Federal Fund futures were pricing only a 32% probability of the Fed increasing rates again this year. A strong, but not too strong, economy with low-interest rates is ideal from an investing perspective. This doesn’t mean we won’t get any market corrections. Volatility has been unusually low, especially given everything going on in the world; we would expect it to move higher. However, without a recession, these corrections can be short-lived and actually be good buying opportunities.
We will eventually get inflation and higher interest rates, as per a normal economic cycle, but we don’t see this happening yet. What about those black swans and gray rhinos? Because black swans are by definition only recognizable in hindsight, we’ll stick with the gray rhinos for now, of which we see four (there are more, but let’s narrow the list to just four this month). Three of these animals we talk about all the time, namely the Eurozone, China, and the Canadian housing market. The last is a little more complicated but is centered on debt and the global economy’s inability to deal with it.
One of the feel-good stories of the year continues to be Europe. Economic growth in the Eurozone has increased for 17 straight quarters and rivals that of the U.S.. Support for far-right political parties fell, partly as a result of the improved economic conditions, but also due to the perceived negative outcomes and other populist victories, such as Brexit and the Trump election victory.
If you are a European watching what is going on in Washington right now, how excited are you for bringing a more radical populist leader to power? Boring old Fraulein Merkel has to look pretty good right now.
The real gray rhino, however, is the flawed structure of the Eurozone. When the Euro was adopted in 1999, it was intended as a first step towards fiscal and political union; that never happened. Now countries like Italy and Greece are stuck with same monetary policy and currency as Germany, even though their economies are structurally much different. The Eurozone unemployment rate has declined to an eight-year low of 9.1%, but structural unemployment remains dangerously high.
What happens in the next recession? Will Germany continue to bail out their southern European neighbors? Will Italy and Greece remain in the EU, despite the economic hardship? There are lots of gray rhinos to choose from here. They are peacefully meandering around the waterhole right now, but for how long?
The Eurozone’s problems might be manageable if not for the high government debt to GDP levels of countries like Italy and Greece. China has the same problem, except corporate debt rather than government debt is their gray rhino. According to the International Monetary Fund (IMF), non-financial sector debt has grown more than 100% over the past five years with debt to GDP hitting 230% in 2016.
As Harvard Professor and ex-IMF Chief Economist Ken Rogoff recently observed, credit growth in China has consistently outpaced GDP growth, sometimes at twice the rate, a situation that is clearly unsustainable. The IMF believes Chinese GDP from 2012 to 2016 would have only been 5.3%, versus the 7.3% reported, if debt had grown at what the IMF considers to be a sustainable pace. The risk, of course, is China could suffer a hard economic landing if the current credit boom were to come to an abrupt end before China is able to develop a more balanced consumer-led economy. In studying 43 past credit booms, the IMF found nearly all of them resulted in a sharp slowdown or financial crisis. China’s taking on more and more amounts of debt to drive GDP growth, with 20-trillion renminbi of new credit in 2015-16 only resulting in a 5-trillion renminbi increase in nominal GDP.
Clearly, a hard landing in China would have negative repercussions for global economic growth. Closer to home, however, what would this mean for the Canadian housing market that has relied so heavily on overseas (Chinese) capital? The Canadian housing market is a gray rhino for a number of reasons. From a debt perspective, Canadian consumers are very vulnerable to increases in interest rates and higher unemployment, but the Canadian economy itself is vulnerable given the above trend percentage of GDP real estate and construction currently represents. A bursting of the real estate bubble will hurt Canadian consumers who are over-leveraged and Canadian workers who build and sell homes. Canada isn’t the only country in the world experiencing a housing boom, but we are certainly one of the most vulnerable.
So far, all our gray rhinos have a common theme. Europe, China, and Canada all have debt problems. In the Eurozone, the problem lies with government debt. China’s problem lies with its corporations, while in Canada, it’s consumers that are over-leveraged.
Debt, in general, is a gray rhino. Excessive debt was one of the major causes of the financial crisis, but the world has not deleveraged. The global economy has slowly recovered, but only because interest rates have been maintained at historically low levels, namely zero. What happens if interest rates start to rise? How high can they go before we slip back into recession? And what do central banks do when we hit the next recession?
Ray Dalio, who runs Bridgewater, the world’s largest hedge fund, believes there are actually two debt cycles. One is shorter term and is associated with the normal economic cycle. Credit expands in a growing economy and contracts once interest rates rise after the economy has overheated and the central bank tightens monetary policy. This is normal and manageable. Investment returns suffer, but the resulting change in valuations and lower interest rates set the stage for the next bull market. In the long term, however, credit growth is constrained by productivity and efficiency growth. We can’t spend more than we earn, and if we try, we eventually hit a crisis point.
To resolve the crisis, debt is either written off, or the economy is able to grow faster than debt. Historically, growing out of a debt problem is very unlikely without inflation playing a major role in boosting nominal growth rates. High inflation is effectively a slow, less visible, way for borrowers to default, and the pain is felt by everyone, not just the lenders.
This gray rhino isn’t a problem right now. We actually believe the Goldilocks economy (not too fast, not too slow) will result in interest rates remaining low for the foreseeable future and economic growth should be ok. We aren’t outgrowing our debt levels, but interest rates are so low it doesn’t matter. We may be entering the late innings in regards to the current economic cycle, but the innings are taking a long time to play out. This is actually a pretty good environment for investment returns and becoming too defensive too soon can also hurt investment returns.
Case in point, a recent Wall Street Journal article highlighted tail risk funds, which are designed to benefit from black swan events, are down about 40% (cumulative return) since December 2007 versus +42% for the S&P 500 (total return in U.S. dollars).
Things might start to get more interesting during the next recession if following the normal short debt cycle playbook of lowering short-term interest rates doesn’t work because we are late in the long-term debt cycle. Debt levels will rise even higher, but already low-interest rates won’t be able to fall enough to stabilize the economy. If this happens and the placid gray rhino quickly turns on us and starts to charge, there are very few investment alternatives that would provide shelter.
Diversification, which includes an allocation to hard assets like gold and real estate, will be crucial in this environment. Investors also need to be cautious of the risk they take in their portfolios because a charging rhino is not a dip you want to buy.
What did you think of August’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. Please speak to your NWM advisor for advice based on your unique circumstances. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is only available for sale to tax residents of Canada who are accredited investors. Please read the agreements and/or subscription documents for additional details and important disclosure information, including terms of redemption and limited liquidity.