By Rob Edel, CFA
Highlights This Month
- The Fed implements the “Yellen (Covered) Call.”
- U.S. presidential race is on the investors’ radar.
- We don’t predict any momentum with the rally.
- March markets may look good but aren’t trendy into the summer.
- What does a lower dollar mean for oil prices?
- U.S. employment is looking up.
- Canadian economy benefiting from the U.S. recovery.
The NWM Portfolio
Returns for NWM Core Portfolio increased 2.0% for the month of March. 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.
Narrowing credit spreads were a main contributor for both bonds and high yield bonds with NWM Bond increasing 1.8% and NWM High Yield Bond +2.0%. High yield bonds would have returned even more had it not been for the 3.9% increase in the Canadian dollar.
The stronger Canadian dollar also hurt what would have been a strong month for global bonds, with NWM Global Bond still up 0.5% in March.
The mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage +0.3% and NWM Balanced Mortgage +0.5% in March. 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 4.5% for the Primary and 5.6% for the Balanced, unchanged from last month. The NWM Primary Mortgage ended the month with cash of $4.4 million, or 2.7%. The NWM Balanced Mortgage ended the month with $18.8 million in cash, or 4.8%.
NWM Preferred Share returned 9.8% for the month of March underperforming the Preferred Share Laddered Index ETF which returned 10.8%. The market had strong returns in spite of three new issues during the month totaling $750 million of new supply. During the month we have been focusing more of our attention to preferred shares where we believe they have a high chance of redemption in the near future, particularly several REIT and bank issues. The fund also increased its position in Dundee, which is a clear example of opportunities arising from the increasing complex preferred share structures. Dundee Securities’ Series 4 Preferred Shares were recently restructured following consultation with several institutional shareholders including NWM Preferred Share. One of the provisions allows us to redeem 15% of our position at par of $25 on June 30, 2016 in addition to the current yield of 8%, amounting to a 12% gain in three months.
Canadian equities were strong in March, with the S&P/TSX up 4.9% (total return, including dividends), and NWM Canadian Equity Income and NWM Canadian Tactical High Income were up 7.8% and 8.3% respectively. In NWM Canadian Equity Income, we trimmed our position in Suncor and added to our existing positions in Enbridge and Prariesky. We also initiated a small position in Valeant, a controversial decision given recent events, but we feel the stock is oversold.
Foreign equities were also strong in March with NWM Global Equity up 3.1% compared to a 2.5% increase in the MSCI All World Index and a 2.4% rise in the S&P 500 (all in Canadian dollar terms). Of our external managers, Edgepoint led the way, up 4.5%, followed by BMO Asia Growth & Income +3.9%, Lazard Global Small Cap +3.6%, Pier 21 Carnegie +2.4%, and Value Invest +1.1%.
NWM U.S. Equity Income was up 7.0% in U.S. dollar terms and NWM U.S. Tactical High Income increased 4.8% versus a 6.8% increase in the S&P 500 (all in U.S. dollar terms). In NWM U.S. Equity Income, we added to our existing positions in Accenture, Visa, and Microsoft. As for the NWM U.S. Tactical High Income, we were called away on our remaining Oaktree position, as well as Hewlett-Packard, and Verizon. We have chosen not to repurchase any of these positions.
Real estate increased in March with NWM Real Estate up 1.6%, with the iShares REIT ETF up 6.3%.
NWM Alternative Strategies was down 2.7% in March (these are estimates and can’t be confirmed until later in the month). Of the Altegris feeder funds, Winton, Brevan Howard, Millenium, and Citadel were down 7.2%, 5.2%, 5.2%, and 4.9%. Again, the appreciation of the Canadian dollar hurt these managers last month by nearly 4%. The performances of our other alternative managers were mainly positive, with RP Debt Opportunities +2.87%, Polar North Pole Multi-Strategy +2.0%, and RBC Multi-Strategy Trust +3.1%. MAM Global Absolute Return Private Pool was down 1.0%. Precious metals had a flat month, with NWM Precious Metals up 0.1%, and bullion decreasing 4.4% in Canadian dollars.
March In Review
The bull market in U.S. stocks turned seven years old in March and global markets celebrated accordingly, with most markets posting strong advances. The S&P 500 rallied 6.8% in local currency term while Canada’s S&P/TSX increased 4.9%, pushing both markets firmly into the black on a year to date basis. China actually led the way with the Shanghai Composite up 11.8%, but is still in negative territory for the year, down 15.1%. Japan also put in a good showing, with the Nikkei 225 up 5.3%, and Europe’s STOXX Europe 600 managed a 1.5% return. Like China, however, both markets remain down for the year. It wasn’t just stocks that did well in March, most risk assets had a good month with high yield bonds, oil, and most commodities finding a bid as volatility retreated.
Why the big risk-on rally? There are a number of factors, but the biggest is that the Fed appears to be turning more dovish and backing away from their previous forecast of four Federal Funds rate hikes (of 1%) this year. Citing global economic and financial uncertainty and the risk it presents to the U.S. economy, Fed Chairwoman Yellen announced no change to its benchmark overnight rate of between 0.25% to 0.50% at the Fed’s March meeting and guided market expectations for future increases lower. The median projection of the 17 Fed officials is now suggesting overnight rates will only increase to 0.875% by the end of this year and 1.875% by the end of 2017.
Even in the long term, the Fed now only expects rates to hit 3.25% versus 3.5% previously. The market thinks the Fed will be even slower to increase rates, with Fed Funds Futures Contracts putting only a 60% probability of even one 25 basis point increase this year and a mere 15% chance the Fed raises rates as soon as June. Even if the Fed does increase just once, it would still be the only central bank tightening interest rates.
This divergent monetary policy stance put tremendous upward pressure on the U.S. dollar earlier in the year and was likely responsible for some of the recent weakness seen in the U.S. industrial production. Any signs of a reversal in the Fed’s plan to raise rates is positive for markets in the short term, as is evident by the sharp rally in U.S. stocks after the text of Yellen’s speech was released.
So the Fed is giving the all clear signal to start buying risk assets again? You wish. The Fed would really like to increase interest rates, and a strong market rally would give them the license to do so. This likely caps the market on the upside, a situation some traders are referring to as the “Yellen (Covered) Call”, which is the opposite of the “Bernanke Put”.
Traders of the day were of the belief that Janet Yellen’s predecessor as Fed boss, Ben Bernanke, stood ready to lower interest rates any time the market looked to be stumbling. Yellen appears to be doing the opposite; standing ready to raise rates if the economy shows strength. As such, traders are not showing a lot of conviction in this rally, with short interest (bearish bets) on the S&P 500 reaching its highest level since November 2009. Safe haven assets also remained strong, with bonds, gold, the Yen and the Swiss Franc all refusing to give up gains made earlier in the year when equities came under pressure.
Apart from what the Fed may or may not do, investors are also concerned about corporate earnings as earnings momentum for S&P 500 companies has been headed lower since last summer and a higher than normal number of S&P 500 companies have issued negative earnings per share guidance for Q1 2016. With the strong rally in stock prices since mid-February, valuations are again above historical averages and are closing in on levels reached before previous corrections.
Perhaps investors are being too cautious? The domestic U.S. economy continues to slowly recover, and a dovish Fed has helped reign in the U.S. dollar, which is good news for exporters.
It’s also good news for China and oil, both of which contributed to market volatility earlier in the year but look to have stabilized of late. Because the Chinese Yuan is loosely pegged to the U.S. dollar, a weaker greenback means a weaker Yuan, thus making it less likely China will be pressured into devaluing their currency. This, in turn, takes a lot of pressure off of Chinese officials struggling to stem the flow of capital out of China, which is evident by the $10.3 billion increase in China’s currency reserves in March.
Same for oil. Oil is priced in U.S. dollars, so a decline in the dollar, all things being equal, means oil should trade higher. Also helping crude prices is higher demand, especially in the U.S., and the expectation U.S. production is finally starting to roll over and isn’t expected to rebound for at least another year, even if prices were to continue to rebound. It will take at least that long to repair the balance sheets of most producers and sweet talk lenders out of more money.
For now, Traders are betting prices continue to move higher, but we admit the situation is fluid. Iran and Iraq continue to ramp up production, jeopardizing a potential production freeze agreement between OPEC and Russia, while U.S. oil storage remains near record levels. There are just too many moving parts to be confident about anything in the oil market. Case in point, the International Energy Agency recently disclosed they are unable to account for 800,000 of the estimated 1.9 million barrels a day excess the world is supposed to be producing. The IEA only tracks OECD storage sources so it could be the missing 800,000 barrels a day found their way into Chinese storage tanks, or maybe they don’t exist at all.
Not everyone is happy about the weaker U.S. dollar, however. Japan and the Euro-zone desperately want to weaken their currencies and a strong dollar makes the Yen and Euro weaker by comparison. If the Fed is raising interest rates, the Bank of Japan and the European Central Bank have to work a lot less at depreciating their currencies.
What has the market puzzled, however, is that Japan and the Euro-zone have actually been working very hard at weakening their currencies, but the Yen and the Euro have moved higher. Both have been aggressively printing money and buying government debt, and both have moved overnight interest rates into negative territory, but to no avail.
Also not moving in the right direction are prices. Apart from stimulating economic growth through a lower currency, Japan and the Euro-zone would also like to increase inflation. Heavy debt loads in both countries have little chance of moderating if GDP doesn’t increase through either real economic growth or inflation. Quite frankly, the central banks of both countries are beginning to look a bit desperate as it appears they are running out of options; another reason for investors to be cautious.
As if investors needed any more reasons for questioning the current rally, the recent drama in the U.S. presidential campaign might finally be creating enough uncertainty to impact capital markets. We are getting down to the short strokes for nominating a Democratic or Republican nominee. While no candidate looks particularly appealing, traders are most concerned with the possibility of either Bernie Sanders or Donald Trump successfully fighting their way to the Oval Office.
In a February Wall Street Journal (WSJ) survey, more than 80% of business, financial, and academic economists indicated the election of either Trump or Sanders may force them to lower their economic forecasts. About 50% rated both candidates as “significant” risks, a fact neither Sanders nor Trump are likely to build into their election campaign slogans.
Number two Republican candidate Ted Cruz is not much better, and there is still the possibility (remote, in our opinion) Democratic top seed Hilary Clinton will be indicted over her email scandal. The reality, any impact the new president may have would unlikely be felt in the near term, and Congress would still have to approve any big changes.
A good month for investment returns, but we question the veracity and sustainability of the risk on rally in March. While slow growth rather than recession is still our best guess for the economy in the near term, caution is still warranted.
The U.S. Economy
Forecasters became less enthusiastic about the prospects for U.S. growth last month, with the average forecast for first quarter U.S. GDP growth in WSJ’s monthly survey of economists falling to 1.3% versus 2.1% a month ago. The Atlanta Fed’s GDPNow forecast is even more bearish, pegging Q1 growth at only 0.1% versus 2.7% in only mid-February.
In fairness, first quarter GDP forecasts tend to be unreliable given seasonal swings in weather and spending patterns during the first three months of the year. Also, the NY Fed has recently started publishing their own GDP forecast, called the FRBNY Nowcast, and it’s closer to the WSJ survey results with a 1.1% forecast. Even if prospects for the first quarter are turning lower, a contraction is unlikely.
The WSJ survey pegs the odds of a U.S. recession over the next 12 months at 19%, down slightly from 20% the previous month, and industrial production indicators all turned positive in March. Industrial production was negative in February, but mainly because unseasonably warm weather lowered heating demand for utilities. Manufacturing production was up 0.2% versus January and +1.8% compared to February last year
March was another strong month for the U.S. job market. The unemployment rate moved up slightly to 5%, but only due to more workers entering the work force. Jobless claims remained under 300,000 for the 56th consecutive month, the longest this has happened since 1973. Encouragingly, the participation rate and wage inflation also moved higher. Aging demographics will limit the rise in the participation rate in the future, but the fact younger workers are more active in the work force and are looking for work, is good news.
Despite remaining low in most advanced economies, U.S. inflationary expectations, and actual inflation, moved up in February. Breakeven yields on Treasury Inflation Protected Securities (TIPS) moved higher last month, meaning investor’s future inflation expectations have increased, and Core CPI advanced above the Fed’s 2% target for first time in three years, led by cyclical components such as apparel, airfares, lodging and motor vehicles.
Import prices have been a big help in keeping prices down over the past couple of years, with declining oil prices and a strong dollar playing a major role. In March, however, non-automotive consumer import prices declined only 0.1% versus the previous year, a substantial turnaround from August when they were down 1.1%. If stronger import prices become a trend, and oil prices and the dollar were to start moving back up, inflation might be headed higher.
It’s too early to be calling recent increases a trend, especially since inflation is typically stronger in the first half year, but it’s an important development which requires close scrutiny in the near term. Weak economic growth and higher inflation are a poor combination for future investment gains.
Consumer confidence moved higher in March, reversing most of the weakness seen in last month’s release.
Consumer spending was weaker in February as Americans appear to be saving more. At 5.4% in February, the personal savings rate hit its highest level since February 2015, near its average rate over the past 20 years. Since 1960, however, the average savings rate has been over 8%, and between 1960 and 1995 it averaged about 10%, leaving room for Americans to become even more frugal. Since the recession, U.S. consumers have done a good job of deleveraging and have only borrowed in line with expected gains in income. This is good news for the long term sustainability of the economy, but bad news for economic growth in the short term.
Existing home sales fell in February as higher prices and low inventories took a toll. Housing starts and builder confidence still remain strong, however. Housing added about 0.25% to U.S. GDP last year, and despite the recent slowdown, we would expect at least as much of a contribution this year.
The U.S. trade deficit in February widened to its highest level since August, helping dampen expectations for first quarter GDP growth.
A bit of a mixed bag for the U.S. economy last month. Manufacturing looks to have rebounded, but consumers have become more cautious. The big driver remains employment, which continues to move along nicely.
The Canadian Economy
Canada’s economy turned in its best month since July 2013 in January, with GDP growing 0.6%. Gains were broad based and included a 1.9% increase in the manufacturing sector.
Not only was GDP strong in January, employment growth delivered a blockbuster month in March, with Canada adding over 40,000 new jobs versus estimates of only 10,000. The quality was also high with 65,000 new jobs coming from the private sector and 35,000 being full time. Even Alberta surprised to the upside, creating 19,000 new positions. Manufacturing, which should be experiencing some strength as a result of the fall in the Canadian dollar, surprisingly lost 32,000 jobs. We are wary of this employment report. We want to believe it, but monthly Canadian job reports are notoriously volatile.
Canadian inflation moved lower in February, mainly due to lower gasoline prices. Food costs remain elevated, increasing 3.9% during the month.
Consumer confidence was strong in March and retail sales delivered its biggest gain since March 2010. Unfortunately, consumer debt reflects a similar upward trend. We continue to worry current consumer spending is stealing from future growth.
With the exception of Vancouver and Toronto, the Canadian housing market continues to moderate. Price increases in both Vancouver and Toronto look to be on an unsustainable upwards trajectory, but demand remains strong and household construction in both cities is growing well above Canadian and international averages. Construction will likely remain a positive contributor to the Canadian economy for the foreseeable future.
Canada’s balance of trade disappointed in February as the trade deficit swelled to its largest level in four months on sharply lower exports. This is disappointing given the weaker loonie, though falling energy prices played a large role in the decline. Exports were coming off highs so the impact on economic growth in the first quarter should be mitigated.
March was a good month for the Canadian economy. We are not sure we trust the sustainability of all the numbers, like the blockbuster employment report, but overall, the Canadian economy appears to be rebounding nicely from the decline in the energy sector. Continued recovery in the U.S. economy remains the largest factor for Canadian growth to continue.
What did you think of March’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.