By Rob Edel, CFA
Highlights This Month
- The Strategic Investment Conference didn’t disappoint.
- How do we reduce debt so economic growth can normalize?
- Is it time to turn to gold and Bitcoin?
- The market weighs tax reform vs. tax cuts.
- Aging investor demographics shift attention to emerging markets.
- China makes moves to regulate credit.
- Canada’s GDP earns a top spot amongst G7 countries.
- China innovates as manufacturing shifts to the U.S.
- What do the economic experts think of U.S. politics?
- Trump creates noise for investors.
- North Korea: the real threat.
- A recession is imminent, just not this year.
The NWM Portfolio
Returns for the NWM Core Portfolio Fund were flat for the month of May. This 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.
Canadian and U.S. yield curves continued to flatten last month with 10-year yields falling more than 2-year yields. In the U.S., 2-year yields actually rose a couple of basis points, compared to an 8 basis point decline in 10-year yields. Normally, a flattening yield curve would be positive for bonds returns; however, the NWM Bond Fund is positioned to have a low average term to maturity (duration) so the benefit was marginal. For the month, the NWM Bond Fund was up 0.1% but is +2.2% year-to-date.
High yield bond returns were also modest in May with the NWM High Yield Bond Fund returning +0.3%. As it was for a number of funds last month, a stronger Canadian dollar hurt high yield bond returns as U.S. dollar assets fell just over 1% due to the appreciation of the Loonie versus the U.S. dollar. Credit spreads continue to tighten, however, are at historically tight levels across the quality spectrum with lower quality credit outperforming higher quality. The strength has persisted despite high yield market outflows year-to-date. The NWM High Yield Bond Fund remains defensive at these tight credit spreads. It has an average duration of three years and currently generates a 4% yield.
Global bond returns were weaker last month with the NWM Global Bond Fund returning -0.9%, with currency attributable for most of the losses.
The mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.4% and 0.5% respectively. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity, all interest and principal were repaid, which are in no way is a predictor of future performance, are 4.3% for the Primary Mortgage Fund and 5.5% for the Balanced Mortgage Fund. NWM Primary Mortgage Fund ended the month with cash of $8.0 million, or 4.8%. NWM Balanced Mortgage Fund ended the month with $49.6 million in cash or 10.1%.
The NWM Preferred Share Fund returned -2.6% for the month of May while the BMO Laddered Preferred Share Index ETF returned -2.3%. Weakness in the market was anticipated as investors took profits after a strong first quarter. However, returns for the overall rate reset universe were also influenced strongly by a few select companies. While both Enbridge and Element preferred shares were down 5% for the month, Aimia was down by about 25%.
Canadian equities were weak in May, with S&P/TSX -1.3% (total return, including dividends). The NWM Canadian Equity Income Fund returned -2.1%, with the financial and consumer discretionary sectors weighing on returns as the market shifted away from the reflation oriented investments. Alternatively, the NWM Canadian Tactical High Income Fund gained 0.1%, despite the decline in the overall market. The fund still maintains a low net equity exposure (current delta adjusted exposure 43%). We added a new position in Westshore Terminals in the NWM Canadian Equity Income Fund, while the NWM Canadian Tactical High Income Fund added to its existing position in KP Tissue.
Foreign equities were stronger in last month, with the NWM Global Equity Fund up 1.7% compared to a 1.2% increase in the MSCI All World Index and a 0.4% rise in the S&P 500 (all in Canadian dollar terms). All our external managers had positive returns last month, with Pier 21 Carnegie +3.1%, Pier 21 Value Invest +2.1%, BMO Asia Growth & Income +2.1%, Edgepoint +0.8%, and Lazard Global +0.1%. Our new internal Europe Australasia & Far East (EAFE) quantitative investments returned +2.4%.
NWM U.S. Equity Income Fund increased 1.5% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 0.8% versus a 1.4% increase in the S&P 500 (all in U.S. dollar terms). In the NWM U.S. Equity Income Fund, we sold our position in CVS. As for the NWM U.S. Tactical High Income Fund, we sold our remaining position in Waste Management.
Real estate was fairly flat in May with the NWM Real Estate Fund up 0.2% versus the iShares REIT Index -0.6%.
The NWM Alternative Strategies Fund was flat in May (these are estimates and can’t be confirmed until later in the month) with Winton -0.7%, Citadel +0.7%, Millenium -0.9%, and Brevan Howard -1.3%. We are still in the process of redeeming Brevan Howard from this fund. Again, a stronger Canadian dollar provided a headwind for these returns when translated back into Canadian dollars. Of our other alternative managers, RP Debt Opportunities was +0.6%, Polar North Pole Multi-Strategy +0.5%, and RBC Multi-Strategy Trust +0.3%.
Precious metals stocks were weaker last month with the NWM Precious Metals Fund -1.8% while gold bullion down 1.1% in Canadian dollar terms.
May In Review
Last month we attended John Mauldin’s Strategic Investment Conference, as we have done every year since 2010, at least. For us, it is a “can’t miss” event; with a great list of speakers and a format that fosters healthy debate in many of the important economic issues of the day.
Yes, some of the speakers are the same year after year, and yes, many of them tend to look at things from a glass half empty perspective, but listening to the same forecasters makes them accountable. Even if we don’t always agree with their conclusions, we benefit from hearing the arguments they make and the facts they present to support them.
As for the bearish bias of the conference, we are fine with that. It’s easy to find people to give you the bull case. One only needs to listen to the pundits on CNBC or any of the other popular media outlets “talking their books.” We are in the business of managing risk, and you can’t manage risk without constantly searching for things that can go wrong; which is a perfect segue to discuss this year’s conference and what happened in the markets and the economy last month. To help make things interesting, we have added some graphics, but point out these are not from the conference or any of the speaker’s presentations.
With that ominous introduction, one might be concerned investment results last month were negative. For the most part, this is not the case. Canadian stocks were lower, with the S&P/TSX Index down 1.3%, but U.S. stocks were higher, with the S&P 500 +1.4% and the technology-laden NASDAQ +2.7%. True, a weaker U.S. dollar shaved those returns down a bit when translated back into Canadian dollars, but year-to-date returns remain strong, in any currency.
Europe and Japanese equities also did well, with the STOXX Europe 600 +1.6% and the Nikkei 225 +2.4%, both in local currency terms. The big driver for stocks was earnings, with first quarter S&P 500 earnings up 15.3% year over year according to Thomson Reuters I/B/E/S, their strongest gains in six years. Some of these gains came as a result of some weak oil and gas earnings last year but even excluding the energy sector, Thomson Reuters estimates profits rose 10%.
With the S&P 500 and the NASDAQ hitting all-time highs, one might expect bond returns to come under pressure, but this wasn’t the case either last month. Bond yields continued to move lower, with 10-year U.S. treasuries ending the month at 2.2%, near their lows for the year.
Higher stock prices typically point to a stronger economy while one normally associates lower yields with weaker economic growth. With the Federal Reserve looking to tighten monetary policy and increase short-term rates, lower 10-year yields resulted in a further flattening of the yield curve.
Two SIC Conference stalwarts, Gluskin Sheff’s David Rosenberg and Hoisington Investment Management’s Lacy Hunt, both highlighted that a flattening yield curve has historically been one of the best predictors of a recession. Of the 16 Fed tightening cycles since 1914, the U.S. economy has avoided recession only three times and, as Lacy Hunt pointed out, the U.S. has never avoided a recession when the tightening occurred this late in an economic cycle. Dr. Hunt pointed towards the sharp decline in M2 money supply and the recent drop in bank lending as confirming his view that a recession is all but a foregone conclusion.
Mark Yusko, CEO at Morgan Creek Capital Management, agreed with Hunt’s assessment that the U.S. economy is rolling over and argued the only reason the yield curve hasn’t inverted yet is that short rates have been artificially repressed by the Fed.
So why is the Fed tightening? Dr. Hunt believes the problem lies with the Federal Reserve’s dual mandate of trying to control employment and inflation. Because the unemployment rate has fallen to levels considered full employment, the Fed believes further stimulus will now only result in higher inflation.
The theory that there is an inverse relationship between the unemployment rate and inflation is called the Phillips Curve; the Fed adherence to this theory is a mistake according to Dr. Hunt. He believes financial stability is the only mandate the Fed should have, and raising interest rates at this time will not lead to financial stability. Inflation is low, with wage growth stubbornly stuck below 3%, and GDP growth and industrial capacity utilization remain well below normalized levels. Dr. Hunt believes raising interest rates at this point will only cause the U.S. economy to fall back into recession.
Martin Barnes, Chief Economist at BCA Research, wasn’t so sure. Mr. Barnes made the point that the Fed isn’t really tightening monetary policy, but just wants to get away from zero interest rates. Zero interest rates were an anomaly. Sure rates will move higher, but the Fed isn’t out to crush the economy. With real rates still negative, we have a long way to go before monetary policy starts becoming restrictive. Also, with a weaker U.S. dollar and lower 10-year treasury yields, despite the Fed raising overnight rates earlier in the year, financial conditions have actually eased, not tightened, in 2017.
Barnes concedes the current cycle is long in the tooth, but he doesn’t see the imbalances typical of expansions that are extended and ready to roll over. He believes economic growth is generally okay. Not great, but good enough. Industrial growth is actually quite healthy and while first quarter GDP was a weak +1.2% (revised up from +0.7%), second quarter GDP is looking to make a nice rebound.
A greater concern to Mr. Barnes would be if the Fed gets behind the curve and inflation starts to move higher; something he thinks can happen even with only 2% GDP growth. If this were to happen, the Fed would be obliged to increase interest rates more aggressively, which would lead to a hard economic landing.
We would tend to agree with Martin Barnes. The Fed isn’t really tightening rates and thus comparing with previous tightening cycles is not as relevant. Where we all might be wrong, however, is if high debt levels have made the economy ultra-sensitive to increases in interest rates, no matter how small. This is really the point Rosenberg and Hunt were trying to make, as both believe too much debt is holding back economic growth and is neutralizing any of the positive productivity gains that we might have from technological innovation.
Maybe the more important question then is how do we reduce debt so economic growth can normalize? This is probably the most important issue for the economy and investors, and sadly, we have yet to hear a convincing solution. Dr. Hunt believes austerity is the only answer but we get the feeling even he doesn’t actually believe this will happen.
Inflation, namely boosting nominal growth through a higher inflation rate (aka, inflating away your debt), has been discussed in past conferences as a potential solution but was only mentioned briefly this year. Most likely believe this is still a viable scenario but inflation has been stubbornly low for so long, despite a monetary policy of biblical proportions. We think the presenters are tired of trying to argue the point and have shifted to presenting the inflation solution in a different way.
David Rosenberg believes there will eventually be a debt jubilee, which is essentially where the central bank prints enough money to buy all outstanding government debt and then effectively writes it off. Pippa Malmgren, founder of DRPM, articulated a similar view, but both were short on the details of how this would actually work. We have spent a lot of time thinking about the debt end-game, and while we struggle to articulate exactly why, our gut tells us a debt jubilee would be very painful and likely result in hyper-inflation. Eventually, all the money printed by the central bank to buy the debt would find its way back into the real economy; when it does, won’t it result in dramatically higher inflation?
This scenario is one of the reasons we believe gold has a place in everyone’s investment portfolio. Gold is effectively a currency whose value can’t be inflated away. Bitcoin has some of the same properties, though we admit we struggle to understand cryptocurrencies and their place in the investment landscape. Interestingly, both gold and Bitcoin moved higher, along with stocks and bonds, last month. Lower bond yields (and more importantly, lower real interest rates) and a weaker U.S. dollar have historically been positive for gold, but its value as an insurance policy against a future financial crisis may also have been playing a role in its popularity last month.
Past presenters have cited fiscal policy as a solution for the current slow-growth economy, as has President Trump. If infrastructure spending and tax cuts boost economic growth such that GDP grows faster than debt, the economy can grow itself out of its debt problems. Presenters at the Mauldin conference were not big believers in this theory. There was some optimism around deregulation but most saw fiscal policy as only having a one-time positive boost to economic growth.
As for tax reform, David Rosenberg and Martin Barnes, who both coincidently live in Canada, pointed out that the U.S. is actually not a high tax country. Lacy Hunt believes it is a mistake to compare the Reagan tax cuts of the 1980’s and the resulting economic growth to what might happen if taxes were cut today given how high debt levels are now. All three presenters along with John Mauldin, believe tax reform, not tax cuts, are the answer and suggest a value-added tax (VAT) would be a good place to start.
According to a recent WSJ article, economists from both the Republican and Democratic parties have scored the impact of replacing the current capital tax system with a pure consumption tax and believe it would result in a 5% to 9% increase in GDP. The market still believes tax reform is possible, though cuts versus reform are more likely, and a VAT is not even being discussed.
Another theme that was mentioned by several presenters was demographics and the negative implications it has for the U.S. economy as the leading edge of the baby boomers start turning 70 this year. Author Grant Williams (Things That Make You Go Hmmm….), Raoul Paul, editor of the Global Macro Investor, and author and publisher Marc Faber all referenced demographics as a reason the emerging markets were more attractive than more developed western economies.
India, in fact, was hailed by more than one presenter as being particularly attractive. There was also a general bias against the U.S., with Marc Faber and Mark Yusko both believing the future path of the dollar will be lower. For others, like Gavekal Research’s Louis Gave, high valuations and reversion to the mean were reasons why they preferred emerging markets and Europe over American stocks.
With monetary stimulus ending in the U.S., there is more investing runway in Europe where central bank bond buying is still going strong. It was a striking change from past conferences where concerns over China and the potential breakup of the Euro had investors betting on the U.S. dollar.
This year, the only person warning against geopolitical over-optimism was George Freidman, who highlighted some of the challenges a country like India still has ahead of them. No longer is the U.S. perceived as the world’s least dirty shirt and preferred investment choice by default. Sure, there were some concerns about China’s corporate debt levels and the future of the Euro, but only in passing. It is interesting that while investors might be looking to get capital into emerging markets like China, capital in the emerging markets continues to try and get out.
Moody’s downgraded China’s debt rating last month, and while strategists can postulate all they want over whether the U.S. yield curve will or won’t invert, China’s yield curve already has. As a result, Chinese stocks have come under pressure with the Shanghai Composite falling 1.1% last month and the Shenzhen down 5.0%, both in local currency terms. China is cracking down on credit, which is a good thing, but the economy will slow as a result.
Given economic growth rates in Europe have matched, and actually surpassed, those of the U.S. GDP growth in the first quarter with annualized growth of 2.3% versus 1.2% in the U.S., we understand why forecasters find Europe attractive; especially given valuations are lower. We would point out, however, if presenters like Lacy Hunt are right and the U.S. is headed for a recession, it is unlikely that the rest of the world will be immune from the fallout.
Also, the Eurozone will need to start thinking about tightening monetary policy soon. U.S. markets corrected in 2013 when the Federal Reserve first began to “taper” their bond-buying program and it’s likely the European Central Bank (ECB) will need to start preparing markets for the eventual end of their quantitative easing program relatively soon. With total assets of $4.5 trillion, the ECB’s balance sheet is now larger than any central bank ever; though the Federal Reserve and Bank of Japan are not far behind. Bank of America Merrill Lynch estimates $1.1 trillion in liquidity has been added to the global financial system this year alone, which is one of the reasons the price of financial assets have been moving higher. The markets have gotten used to this steady source of demand.
Canada will also have to start rethinking its monetary policy. GDP growth in the first quarter of 2017 annualized 3.7%, earning Canada top spot amongst G7 countries. With 54,000 new jobs created in May, the Bank of Canada appears to be preparing markets for its first rate increase since 2010. While David Rosenberg didn’t mention the Canadian dollar at the conference, he has subsequently stated his belief that the Loonie is undervalued, especially given where oil is currently trading. At near $50 a barrel, Rosenberg feels the Canadian dollar should be closer to 79 cents.
Perhaps just as interesting as what concerned presenters at the conference was what didn’t concern them and what they didn’t talk about. We agree with Lacy Hunt that too much debt was one of the factors behind the financial crisis, and the inability to deleverage is preventing the economy from normalizing. But what caused the debt accumulation in the first place?
Debt began to build in the decade prior to the financial crisis, so you can’t blame the great recession for high debt levels. We also believe demographics could be a headwind for growth in the years ahead but we don’t think demographics caused the financial crisis and the slow growth recovery.
We believe much of the blame can be attributed to the massive global trade imbalances that have been building since the early 1990’s, with China and Germany’s trade surpluses financing much of debt American consumers accumulated. We found it interesting that no presenter directly addressed this issue. Perhaps a consumption tax (VAT), which several presenters mentioned, was the only recognition that an imbalance exists and needs to be dealt with before the global economy to move forward.
Certainly, some of this is self-correcting. Automation will result in manufacturing coming back to the U.S., and higher wages are already reducing China’s competitive advantage as a low-cost provider. This is why China is trying to move up the value chain and produce higher value-added goods. It’s also why China is investing in global infrastructure with its “One Belt, One Road” initiative. Trump may be fighting yesterday’s war with his anti-globalization rhetoric but he is not wrong in identifying it as a factor for the decline in the average American worker’s fortune.
We were also struck by how little emphasis the presenters put on politics and the influence it has on their forecasts, good or bad. Last month, markets finally began to look a little rattled by what was happening in Washington, with Trump being accused of obstruction of justice after firing FBI director James Comey. Most of the presenters, while not Trump supporters, didn’t see a case for impeachment. Bad judgment, perhaps, but guilty of colluding with the Russians – not by the evidence disclosed so far.
Pippa Malmgren didn’t see where Trump broke any laws and believes we are supposed to talk to the Russians, while Ian Bremmer pegged chances of impeachment at only 5%. As for the obstruction of justice charge, as Carl Rove pointed out in a recent Wall Street Journal article, “because the president is in charge of the executive branch, he does not obstruct justice by questioning if a subordinate should, or shouldn’t, pursue a given case”.
Trump may come close to crossing the line, but even by Comey’s accounting of the incident, Trump didn’t order him to drop the investigation; even if he did, Article II of the Constitution vests the authority to oversee all federal law enforcement with the president, and thus the ability to order the end of any investigation (even one focused on the White House itself).
Of course, the real arbiter of the impeachment process is not the law, but rather, public opinion. If Trump loses the confidence of the voters, Congress will act. Bremmer’s biggest fear actually isn’t impeachment but rather that some of the very capable people Trump has surrounded himself with, like National Security Advisor H.R. McMaster and Secretary of Defense James Mattis, quit the Trump administration; leaving the President without a source of good advice the next time a serious crisis arises.
Bremmer also believes the press is biased and being unfair in its coverage of Trump, guilty of a committing a breach of trust by missing the big issue, namely the election of Trump was a protest vote. Despite all the noise, however, most presenters were not basing their investment decisions on Trump, or politics in general. Oh, and if Trump is tossed and Vice President Pence takes control of the White House, the markets could actually move higher. Pence is described as devoutly religious, a former altar boy, monogamous, well liked by colleagues and avoids using profanity. In addition, he supports free trade, is pro-business, and when he was governor of Indiana he was known as a budget cutter. So why didn’t he get the Republican nomination?
The one geopolitical issue that might move markets, however, is North Korea. George Friedman kicked off the conference with an after-dinner presentation in which he assigned a 70% probability on the U.S. attacking North Korea within the next several weeks. Friedman based his prediction on a number of events that led him to believe the U.S. is preparing to strike; including the fact the U.S. had sent two aircraft carrier strike forces to the region, the USS Carl Vinson and the USS Ronald Reagan.
While it could be argued this is meant as a show of force, Friedman pointed out that this is a very expensive move and the Navy doesn’t like to disrupt normal maintenance schedules unless absolutely necessary. The fact the U.S. has since sent the third carrier to the Pacific, the USS Nimitz, further bolsters Friedman’s case.
In addition to the carriers, Friedman pointed to the recent deployment of F-35s to Japan, 100 F-16s running daily missions near the North Korean border, and B1 bombers from Guam conducting joint drills with the South Korean air force. He mentioned top U.S. brass, including the Chief of Naval Operations, recently visited Guam, which they normally loathe doing this time of year, and the Guam Chamber of Commerce was briefed by the Department of Homeland Security on civil defense. Guam is important because it is a strategic airbase for B1, B2, and B52 bombers which would likely be instrumental in any conflict with North Korea.
Why the focus on North Korea? Recent advances in ballistic missile technology have increased the chances North Korea would be able to hit the lower 48 states with a nuclear weapon within a few years. Harald Malmgren also pointed out that North Korea appears to have gained the technology to use solid fuel rockets, which is a game changer because it enables North Korea to launch with virtually no warning.
No one else at the conference agreed with Mr. Friedman’s view that a strike was imminent, however, Harald Malmgren stated that he knew General Mattis personally and felt Mattis would do everything possible to avoid a conflict.
China is still the key to avoiding a war given China holds huge sway over the North Korea economy. Pippa Malmgren believes the U.S. could broker a deal with China by letting China effectively take control of North Korea in exchange for China investing in U.S. infrastructure. The Washington Post recently ran an article speculating that ex-NBA star Dennis Rodman may be headed to North Korea at Trump’s request. Nope, we’re not making this up. This is serious stuff, no jokes. Let’s hope that a deal gets done, because a conflict with North Korea would be devastating, for humanity as well as the markets.
Barring a war on the Korean peninsula, we think concerns over the market and the U.S. economy are over-done. A pull back in the short-term is quite possible, but we don’t see signs the economy is over-heating. Central banks will be extra cautious in removing monetary stimulus, especially if we do get a market correction. U.S. markets may lag in the short term as other markets catch up, but if the U.S. economy goes into recession, we don’t see how Europe or the emerging markets could avoid following U.S. markets lower.
Longer term, we do think elevated debt levels will need to be dealt with before growth can return to more normal levels, and the next recession, when it occurs, will be particularly painful. We just don’t think it will happen this year.
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.