By Rob Edel, CFA
Highlights This Month
- A bearish outlook at this year’s Mauldin Conference.
- Fiscal policy is not the answer but neither is monetary policy.
- Has the Fed missed their opportunity to raise rates?
- Secret Currency Accord: what happened in Shanghai?
- Academics take over the Fed.
- Deleveraging: the 8 year cycle.
- U.S. politics cause heightened volatility.
- Mixed bag of opinions when it comes to China.
- Investors turn to gold during monetary confusion.
- What do we see ahead for the markets?
The NWM Portfolio
Returns for NWM Core Portfolio increased 1.8% for the month of May. NWM Core Portfolio 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.
Lower interest rates helped boost fixed income prices in May, but narrowing credit spreads were the main driver for both bonds and high yield bonds with NWM Bond increasing 0.9% and NWM High Yield Bond +2.3%. High yield bonds were also helped by the 4.2% decline in the Canadian dollar.
Global bonds also benefited from the weak loonie, with NWM Global Bond up 1.9% in May.
The mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage and NWM Balanced Mortgage both +0.4% in May. 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 4.3% for the NWM Primary Mortgage and 5.6% for NWM Balanced Mortgage. NWM Primary ended the month with cash of $10.8 million, or 6.9%. NWM Balanced ended the month with $26.9 million in cash, or 6.7%.
NWM Preferred Share was relatively flat for the month of May, up 0.6%, while the BMO Laddered Preferred Share Index ETF was down 0.5%. The month was marked by a relatively quiet period in new issues with only Brookfield Renewable Partners coming to market with a 5.75% fixed reset. Notable was the lack of new bank preferred shares given several banks need to come to market.
Even though bank earnings season is coming to a close and summer is quickly approaching (generally a quieter period), we think bank issuance may continue to be muted. TD recently issued a 5-year covered bond which continues to highlight the expensive cost of financing preferred shares. Our trading in Dundee has worked out well for NWM Preferred Share as prices jumped 90 cents over the course of three days during the month as the market realized the potential to redeem a portion of their shares trading at $22.50 for $25.
Canadian equities were strong in May, with the S&P/TSX up 1.0% (total return, including dividends), and NWM Canadian Equity Income and NWM Canadian Tactical High Income were up 2.4% and 1.6% respectively. In NWM Canadian Equity Income, we initiated a new position in Morneau Shepell and sold our holding in CAE. We also got called away on half of our Canadian Tire position. In NWM Canadian Tactical High Income, we added a new short put position in Boyd Group Income Fund and added to our existing long only position in KP Tissue. We also closed out our short put position on Shaw Communications and were called away on our WSP Global position.
Foreign equities were also strong in May with NWM Global Equity up 4.3% compared to a 5.0% increase in the MSCI All World Index and a 6.2% rise in the S&P 500 (all in Canadian dollar terms). Of our external managers, Pier 21 Value Invest led the way +5.3%, followed by Lazard Global Small Cap +4.7%, Pier 21 Carnegie +4.6%, BMO Asia Growth & Income +3.8%, and Edgepoint +3.4%. NWM U.S. Equity Income was up 1.1% in U.S. dollar terms and NWM U.S. Tactical High Income increased 0.4% versus a 1.8% increase in the S&P 500 (all in U.S. dollar terms). In NWM U.S. Equity Income, we established new positions in Stryker and Newell, sold our entire position in Qualcomm, and trimmed our existing positions in United Technologies and CBS. As for NWM U.S. Tactical High Income, we disposed of our position in Coach after being called away.
Real estate increased in May with NWM Real Estate up 2.3%, with the iShares REIT ETF up 0.9%.
NWM Alternative Strategies was up 2.8% in May (this is an estimate and can’t be confirmed until later in the month). Of the Altegris feeder funds, Winton, Brevan Howard, Millenium, and Citadel were up 2.5%, 4.3%, 5.9%, and 5.8%. Again, the decline in the Canadian dollar helped these managers last month by over 4%. The performances of our other alternative managers were also positive, with RP Debt Opportunities +1.2%, Polar North Pole Multi-Strategy +1.3%, RBC Multi-Strategy Trust +0.8% and MAM Global Absolute Return Private Pool +15%. Precious metals had a down month, with NWM Precious Metals -5.6%, with bullion decreasing 2.05 in Canadian dollars.
May In Review
Markets moved materially higher in May with Canada’s S&P/TSX up 1.0% and the S&P 500 +1.8%. Weakness in the Canadian dollar meant U.S. stock returns were even better, with the S&P 500 returns translated into Canadian dollars up nearly +6.2%. We should note, even though the Canadian dollar weakened just over 4% last month, it was more about U.S. dollar strength than Canadian dollar weakness, and the loonie is still up over 5% year to date.
Other global exchanges were also strong, with Europe’s STOXX 600 up 4.3%, while China’s Shanghai Composite and Japan’s Nikkei 225 were up 2.7% and 5.7% respectively in Canadian dollar terms. Why the strength, and is it sustainable? To answer these questions and more, this month we are going to supplement our regular monthly research with observations from the recent John Mauldin Strategic Investment Conference.
We have been regular attendees at the Mauldin conference over the past several years as we find the line-up of speakers to be as good as any we have seen, and this year was no exception. Below we will highlight some of the major themes discussed, as well as our thoughts on how they impact the markets and economy. We have added some graphics to help illustrate the issues, but point out that these are not from the conference or any of the speaker’s presentations. We also caution readers, while Mauldin conferences have historically been a somewhat bearish affair, this year’s was particularly depressing. Read on at your own risk.
Central bank monetary policy was probably the most discussed subject at the conference, with more than one speaker expressing their concerns and speculating on what the end game might look like. Despite zero interest rates and aggressive quantitative easing, the U.S. economy does not appear to be gaining any traction. Gluskin Sheff’s David Rosenberg was bullish on the markets and the economy last year, but came back this year in a much more somber mood. Income growth has been stagnant, deleveraging hasn’t happened, and capital investment has continued to lag.
New to the conference, Dr. Pippa Malmgren, an American policy analyst and founder of the DRPM Group, believes high debt levels and lack of deleveraging are two of the reasons growth has faltered and productivity has lagged. Dr. Malmgren believes it is the Federal Reserve’s plan to lower debt levels by letting the economy “inflate away” debt, and inflation is really just a form of default. Malmgren believes we are already experiencing more inflation than Central Bank data would have us believe, as many consumers can attest.
This view was not shared by many other presenters as deflation was still highlighted as a greater near-term risk. In particular, Hoisington Investment Management’s Dr. Lacy Hunt and economist Dr. Gary Shilling, have been warning about deflation for the past several years. Shilling has even written a book on the subject. Malmgren’s end game scenario of inflation-led growth reducing debt levels differed from Rosenberg, who believes higher tax rates for the ultra-wealthy are needed to help balance the books, claiming it was a better solution than inflation. We are not sure if Rosenberg has done the math to determine how much taxes would need to increase or how what his definition of ultra-wealthy is.
Consensus thinking in investment and economic circles is that monetary policy is a spent force. It was needed in order to restore liquidity during the financial crisis, but can’t increase economic growth or generate productivity by itself. In fact, some expressed the view that improper use of monetary policy as far back as the late 1980’s led to its current over reliance by central banks and has helped create imbalances in the allocation of capital and asset valuations. To put this in more simple terms, low interest rates and excess capital helped create the housing boom, which in turn created the financial crisis.
GaveKal’s Charles Gave articulated in more detail the concern that low interest rates are a disaster and distorts capitalism. The economy needs “creative destruction” whereby inefficient and unprofitable companies are allowed to go under. Only companies with attractive returns on equity should be able to have access to the capital markets. When money is essentially free, the hurdle is set too low. The notion that you can’t solve the problem of too much debt with more debt was a point made by several presenters.
Interestingly, Charles Gave’s partner, Anatole Kaletsky, was one of the few to offer a different perspective, suggesting debt didn’t necessarily need to be re-paid and as long as interest rates remain low, the current environment was sustainable. In Kaletsky’s view, debt re-purchased by central banks should no longer be counted as debt given the interest was being paid from one government entity to another. If true, Japan should no longer be considered the developed world’s most indebted nation given the amount of government debt the Bank of Japan has purchased.
The notion that more debt isn’t already too high would appear to rule out fiscal policy as a solution to the global economy’s slow growth predicament. This is not consensus, given most economists have been arguing government should be doing more and incurring larger budget deficits in order to spur growth. In fact, one reading comments in the financial press would be left with the impression that, if not for political gridlock in Washington (and globally for that matter), we would have more government spending and economic growth would be all the better for it.
To our surprise, credit strategist Michael Lewitt was one of the few presenters at the conference to make this case, stating “we need public servants with courage.” Gary Shilling talked about infrastructure spending potentially playing a role and Rosenberg made the comment about higher taxes, but we were struck by the absence of fiscal policy proponents given how prevalent this view has been in the popular press, and by presenters at last year’s Mauldin conference.
This year, there was a great emphasis on future government debt obligations and the burden they present. We would agree that fiscal policy isn’t the answer. Targeted investments in infrastructure projects providing future economic benefits and return would be the exception, but how good are governments at doing this?
So if monetary policy is spent and fiscal policy isn’t the answer, what is? According to Lacy Hunt, austerity is the solution. Austerity is hard work, however, and not much fun. Who wants that? Certainly no politician, if they want to get re-elected.
And what if the current “feeble” economic recovery is interrupted by a recession? Trying to predict what the Fed might do then is where things start to get a little scary, with the possibility of negative interest rates and helicopter money both up for discussion. While not definitively ruling it out, the Fed has generally downplayed the potential of following the path of Japan and Europe into negative interest rate territory.
For this reason, the Fed would really like to raise interest rates in order to have the option to lower them again in the future if the U.S. economy slows. Given recent positive economic trends, the market appeared resigned to an increase in interest rates in either June or July.
The U.S. dollar rallied last month in anticipation of a rate hike, but stocks also rose, possibly reflecting the good news of a stronger U.S. economy. The fact stocks moved higher even as the chances of a rate hike increased was a good sign. In early June, however, the U.S. reported weaker-than-expected employment data for May, which could delay another increase in the Fed funds rate until September.
A delay in the Fed’s plan to raise rates isn’t necessarily bad for the markets, but the reason for the delay could be. If the poor jobs number is a sign that the U.S. economy has hit a soft spot, it could mean the Fed has missed its window of opportunity to raise rates and re-stock their monetary policy ammunition.
The negative impact that higher short-term rates could have on the still fragile economic recovery is one problem. The other is, if the U.S. is tightening monetary policy while all the other central banks of the World are easing (specifically Japan and the Euro-zone), the U.S. dollar will strengthen. This will put downward pressure on commodity prices (including oil) and upward pressure on the Chinese yuan, which is loosely pegged to the greenback.
Given the slowing Chinese economy and its reliance on exports, a stronger currency is the last thing China needs right now and many feel China could decide to devalue the Yuan. This would be bad for everyone, especially other emerging market economies that compete with China for exports.
In order to avoid this risk, many believe a secret currency accord was reached at the recent G20 meeting in Shanghai, whereby the U.S. Federal Reserve agreed to only slow and measured increases in short term rates, while the Bank of Japan and ECB would refrain from lowering rates even further into negative territory.
David Zervos, Jefferies Chief Market Strategist, devoted a large part of his presentation to this issue and stressed the risk of the yuan/dollar peg being broken was at the heart of every asset trade, but there should be peace in the currency war until after U.S. elections in November. After that, he believes everyone prints money as he shares Pippa Malmgren’s view that monetary policy is being used to inflate away government debt. Zervos (and Malmgren) didn’t say it’s a good thing, or even that it will work, just that this is the goal of the central banks when they print money and buy government bonds.
While the yen and euro weakened a bit in May, they have generally been gaining strength so far this year, and continued to rally in early June. In combination with the Fed continuing to stay on the sidelines, it appears the Shanghai currency accord (if it in fact exists) is holding. This is good news if you believe keeping the Chinese yuan pegged to the U.S. dollar is the number one priority. It’s not so good if you believe a weaker currency is needed to help the Japanese and Euro-zone economies, or if you believe the Fed needs to move interest rates higher in order to have some ammunition available in case the economy slows.
Several presenters, Jim Grant in particular, feel central bank credibility is a key risk for the markets and could be the catalyst for a market correction. Grant writes a twice-monthly publication called Grant’s Interest Rate Observer, though Grant quipped during the conference that he wished there were still interest rates to observe. Grant pointed out how unusual it is for one strain of academic theory to dominate the Fed (and other central banks) for as long as it has.
While there were a couple different figures thrown out, the number of PhDs at the Federal Reserve was said to number between 700 and 1,000. Gone are the days of the market savvy and street wise Wall Street Banker running the Fed. These are academics trying to apply text book economic theories to a world that is in uncharted territory. Ricard Fisher, the former governor of the Dallas Federal Reserve, who proudly highlighted he was not a PhD, stated the Fed knows what to do, (which in his opinion is raise rates), but are afraid to do it.
Morgan Creek Capital Management’s Mark Yusko told the amusing anecdote of Fed Governor Janet Yellen’s habit of arriving at airports hours early before her scheduled flights. She is not a risk taker. She will be very cautious in raising rates. As John Mauldin quipped, central banks have painted themselves into a corner. They have no room to lower rates, and raising them could result in a correction in the capital markets and undo all the progress made in the recovery so far. And as mentioned above, what happens if we have a recession, which more than a few of the speakers were concerned about?
Starting to get a little nervous? Ok, let’s walk you back from the ledge a bit.
While geopolitical analyst George Freidman held the view the World was going to hell, he felt North America was fine. Exports are a relatively small component of U.S. GDP, thus insulating America from turmoil in Europe, China, and the Middle East. Even better, U.S. strength will take Canada, and especially Mexico along for the ride.
Mexico was mentioned by more than one speaker as a huge success story. We read about all the drug wars, but this mainly impacts the border region. The rest of Mexico is booming. Despite Donald Trump’s plans to build a wall to keep illegal immigrants out, two speakers made the point that net immigration from Mexico has actually turned negative, meaning more people are returning to Mexico than coming to America.
The last individual speaker of the conference was even more bullish on America. Harvard Professor (and soon to be Stanford Professor) and financial historian, Niall Ferguson, is typically one of the most entertaining speakers at the Mauldin conference, and his presentation this year didn’t disappoint.
Taking an admittedly contrarian view, Ferguson doesn’t buy the secular stagnation argument being espoused by fellow Harvard academic Larry Summers, but rather argued the first quarter of this year was an inflection point for the U.S. economy, and inflection points are usually only noticed well after the fact.
Referencing the work of Reinhold and Rogoff (Ken Rogoff is also at Harvard), who teamed up to write the definitive reference book on deleveraging “This Time is Different,” Dr. Ferguson pointed out deleveraging cycles typically take 8 to 10 years. According to his math, this means we should be nearly done. I guess he missed the earlier presentations highlighting that deleveraging hasn’t even started yet. Regardless, Fergusson believes quantitative models used by the Federal Reserve are flawed and using history as a reference is the best method for forecasting the economy.
Seeing increases in commodity prices and a tightening labor market, makes Ferguson believe monetary policy is working, just with a lag. He believes the Fed should wait until inflation hits 4% before thinking about raising rates. Along with perhaps Anatole Kaletsky, Ferguson was the lone bull at the conference, which is unusual even for a Mauldin event.
When we look at the U.S. economy and current trends, we have to agree that an argument could be made that the recovery is on track, albeit a very slow track. The Atlanta Fed’s GDPNow indicator is forecasting Q2 GDP growth in the U.S. will rebound to a respectable 2.5%, despite May’s disappointing job report. Consumer confidence remains strong, and the housing market appears to be getting its second wind. Are things really as bad as most of the speakers make it out to be?
Even Niall Fergusson and Anatole Kaletsky added some caveats to their relatively bullish outlooks, namely politics and China. A common question from clients lately has been the potential risk to the markets of a Donald Trump presidency. Our standard reply is that the risk is somewhat mitigated by congress. In order to get anything done, the Donald will need to get the House of Representatives and the Senate on-side, and even if they are both still under Republican control, it is far from certain that they will be under Trump’s control.
The possibility of Trump getting elected, however, adds volatility to the markets, as does a potential Clinton victory for that matter. Both have historically high disapproval rates. Hillary has the added burden of trying to reconcile an ideological split in her party, given Bernie Sanders, who refuses to go away despite the inevitability of Clinton clinching the nomination, has driven the party decidedly to the left. Bernie, like Trump, is the anti-establishment candidate, but he is also a socialist, and I’m not sure how well this will resonate with the broader electorate come November.
As wacky as it might sound, don’t count Trump out. Even at the Mauldin conference, Trump had his supporters. Demographer and best-selling author Neil Howe stated that while he believed Hillary might win in November, history wouldn’t treat her presidency well given the generational changes occurring in America and the need for a leader to help facilitate it.
But it’s not just American politics that have Fergusson and Kaletsky hedging their bets; it’s the global anti-establishment movement that is also behind the growing support of Brexit (Great Britain leaving the European Union) and the German right-wing populist movement.
The economic fallout from Britain leaving the EU is hard to forecast, but it would be a complicated and disrupting event. Just for starters, new trade deals would need to be negotiated with all EU members. In the case of Germany, Angela Merkel has been a stabilizing presence for Europe since being elected Chancellor in 2005. A change in leadership would be bad news for capital markets.
As for China, the risks are well known. The need for structural reforms is being weighed against the risk of a hard economic landing and resulting social unrest. China’s industrial sector is over-built and is accumulating too much debt, but shutting down capacity would negatively impact economic growth and cost many workers their jobs. On balance, most speakers were generally dismissive of China’s economic future, believing they had seen this movie before with Japan.
Louis-Vincent Gave, the third Gavekal Research presenter at the conference, was much more upbeat on China’s prospects. Louis conceded Northeast China is in a deep recession due to an over supplied steel industry, but cities like Shanghai and Beijing look pretty strong. He doesn’t see China’s economy imploding and is encouraged by the rebound in the construction sector the past few months.
As for a debt crisis, Gave made the point that China’s debt-to-GDP was still lower than the U.S. and is mainly domestically financed. Credit crises are less likely to occur in countries that run current account surpluses. As for China’s banks, most loans are funded through deposits and loan books tend to be fairly conservative. Louis-Vincent, who happens to be Charles’ son and is based in Hong Kong, feels Chinese stocks are cheap, and with monetary and fiscal policy helping smooth out returns, less risky than U.S. assets, which he views as a crowed trade.
So what does this mean for your investment portfolio? Well, as one can imagine, most were pretty defensive in their advice. According to the deflationists, namely Lacy Hunt and Gary Shilling, bonds are still the place to be – pretty brave if Pippa Malmgren is right and inflation becomes a bigger concern.
Charles Gave believes we are already in a bear market while Richard Fisher commented that most of the smart money he knows is in cash. Mark Yusko believes valuations are too high and the market is dependent on quantitative easing. He believes the market may have one more rally in it before rolling over. He prefers less liquid alternatives, like private equity.
Gold was a popular choice amongst a number of the participants. During a panel discussion on portfolio construction, all three speakers spoke favorably about gold. Jim Grant had a particularly insightful view on gold, saying it is an investment in monetary confusion. Investors can’t short central bank prestige so they should buy the asset which competes against central banks, gold.
Overall, we are not as bearish as most of the speakers at the conference. We see the U.S. economy slowly recovering and don’t anticipate more than a token tightening in interest rates over the immediate future. Equities in this environment could do quite well. They are not cheap, but then what is?
We have to admit, however, we find the current dependence on monetary policy disturbing and the trend towards negative interest rates downright terrifying. We remain of the opinion that deleveraging is painful and efforts to avoid the pain through ultra-low interest rates or by increased government spending (more debt) will only delay the inevitable. We spend a lot of time thinking about what the end game will look like and what it will mean for different asset classes.
We agree with Niall Ferguson that history may be better than economic models in forecasting the future, but we are so far into uncharted waters that we are not sure what to use as an historical reference. In our opinion, diversification remains the best alternative in these uncertain markets. And yes, that includes a little gold.
What did you think of May’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.