All eyes are on Britain as the global markets react to Brexit.


By Rob Edel, CFA

Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

Returns for NWM Core Portfolio declined 0.2% for the month of June.  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.

Interest rates moved lower in June, thus helping bond returns.  NWM Bond was flat; however, the short duration of our managers resulted in very little exposure to the rally in rates during the month.   We have cashed in our position invested with one of our alternative managers and allocated a portion of the portfolio to a private debt fund managed by Sun Life.

High yield bonds benefited from narrowing credit spreads, particularly in the energy sector, but this was partially offset by a stronger Canadian dollar. NWM High Yield Bond increased 0.3% in June.  We are now managing a portion of the fund internally, focusing on lower-beta high yield credit opportunities.

Global bonds were volatile in June due to Brexit and big moves in many currencies.  NWM Global Bond was up 0.2%, hurt by the low duration positioning of our managers, but more than offset by favourable currency positioning, despite the appreciation of the Canadian dollar.

The mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage and NWM Balanced Mortgage both +0.4% in June.  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 are predictors of future performance, are 4.4% for NWM Primary Mortgage and 5.5% for NWM Balanced Mortgage.  NWM Primary ended the month with cash of $8.2 million, or 5.3%.  NWM Balanced ended the month with $38.3 million in cash, or 9.4%.

NWM Preferred Share fund was down for the month of June returning -0.9% while the BMO Laddered Preferred Share Index ETF was down 1.32%. The sell-off in preferred shares occurred mid-month and staged a small recovery at the tail end of the month in spite of Brexit. Preferred shares remain illiquid and with lower volumes associated with summer months, aggressive trading can cause even greater market impact.

This appears the case mid-month, as a large holder liquidated positions pushing the market lower. We anticipated further recovery as selling pressures have abated. In terms of positioning, we received proceeds from our partial redemption of Dundee at par ($25) which is currently trading at $24. Dundee Series 5 continues to trend higher as the market realizes the benefits of concessions that were made to holders after restructuring earlier in the year.

Canadian equities were up modestly in June, with the S&P/TSX +0.3% (total return, including dividends), however, NWM Canadian Equity Income and NWM Canadian Tactical High Income were down 2.7% and 1.8% respectively.  Most of the variance in both portfolios was due to the gold sector, which was up 20% in June.  The utility sector was also strong, increasing over 4%.

Both NWM Canadian Equity Income and NWM Canadian Tactical High Income do not hold any gold or utility stocks.  Also hurting performance in NWM Canadian Equity Income were financials, especially insurance companies. We were called away on part of our SNC Lavalin position and used the proceeds to add to our exiting holdings in Alimentation Couche-Tard.  In NWM Canadian Tactical High Income, we added a new short put position in Sleep Country Canada and sold our position in Diversified Royalty.

Foreign equities were mixed in June with NWM Global Equity down 2.7% compared to a 2.0% decrease in the MSCI All World Index and a 0.7% decline in the S&P 500 (all in Canadian dollar terms).  Of our external managers, BMO Asia Growth & Income led the way +1.8% followed by Pier 21 Value Invest +0.5%.  Pier 21 Carnegie, Lazard Global, and Edgepoint were all in the red, declining 2.3%, 4.4%, and 6.1% respectively.

NWM U.S. Equity Income was down 1.8% in U.S. dollar terms and NWM U.S. Tactical High Income decreased 1.3% versus a 0.3% increase in the S&P 500 (all in U.S. dollar terms).  In NWM U.S. Equity Income, we established new positions in Mohawk Industries and sold our remaining position in Oracle.  We also trimmed Walmart and HP Inc. and used the proceeds to add to our existing positions in Home Depot and Microsoft.  As for NWM U.S. Tactical High Income, we wrote new naked put positions on Lazard and Service Master.

Real estate increased in June with NWM Real Estate up 1.3%.  A strong REIT market was the driver, as was evidenced by the +5.9% move in the iShares REIT ETF.

NWM Alternative Strategies was flat in June (this is an estimate and can’t be confirmed until later in the month).  Of the Altegris feeder funds, Winton was up 3.7%, but Brevan Howard, Millenium, and Citadel were down 0.3%, 1.6%, and 1.8% respectively.  All were hurt by the 1.2% appreciation of the Canadian dollar.  With the exception of MAM Global Absolute Return Private Pool, which was down 3.3%, the performances of our other alternative managers were positive, with RP Debt Opportunities +0.5%, Polar North Pole Multi-Strategy +0.9%, and RBC Multi-Strategy Trust +0.2%.  Precious metals had another strong month, with NWM Precious Metals +17.3%, with bullion increasing 7.3% in Canadian dollar terms.

 June in Review

Wow, we didn’t see that coming.  We are, of course, referring to the results of the June 23rd referendum asking Britons whether they wished to remain in the European Union.

Brexit (the British withdrawal from the EU) has been cited as a tail risk event for markets, but no one really thought it would happen.  The polls were too close to call, but most felt the undecided vote would move towards the status quo at the last minute, as it did for the vote for the 2014 Scottish independence referendum and the 2015 general election.  The bookmakers, in fact, pegged the odds of “leave” winning at below 10% on the day of the vote, skewed lower by large bets made in the city of London, which voted heavily in favour of remaining in the EU.  According to Ladbrokes PLC, bets made outside of London were roughly 80% in favour of “leave”.

Who knew?  With the final vote tilted 51.9% versus 48.1% in favour of Brexit, a deeply divided Britain was exposed, both geographically and demographically.  Scotland and Northern Ireland voted to remain part of the EU, as did younger voters and those with a higher education.  Oddly, regions more economically dependent on the EU tended to favour leaving.  Sunderland, for example, is considered Britain’s Detroit given its dependence on the auto industry, and they voted 61% in favour of Brexit.

The theory that perhaps many voter’s decisions were not well thought out was supported by reports from Google Trends that the second most searched phrase in the UK after the vote was “what is the EU”, followed by “what happens if we leave the EU”.  Concerns over immigration and the vague idea of a “British identity” appeared to dominate voter motivation in voting for Brexit.

MMC1

The market reaction was swift, with the British Pound dropping 8% against the U.S. dollar the next day and a further 6% over the following weeks to levels not seen in over 31 years.  What was perhaps more interesting, however, was the reaction of global markets, which is of more interest to us.  Britain may be the world’s fifth largest economy (or sixth now given the fall of the Pound) and will likely feel the economic repercussions of its decision over the coming months and years, but the UK accounts for less than 4% of the world’s global imports of merchandized goods.  Is the impact of Brexit that significant to the global economy?  According to the market’s reaction, the answer is yes; and because of this, we will look at how Brexit might play out, what it means for the rest of Europe, and how it might impact the U.S. and other markets like China and Japan.

MMC2

First off, is Brexit bad for Britain?  Many Britons who voted to leave were having second thoughts the next day, not really expecting to win, but rather hoping to send a message.  An on-line petition four days after the vote calling for a mulligan had nearly 4 million signatures.

Ex-City of London Mayor and MP Boris Johnson campaigned for Brexit and was considered a prime candidate to succeed David Cameron as PM, but even he appeared to be suffering a bit of buyer’s remorse the next day, back peddling after the vote, saying changes “will not come in any great rush.”  Johnson has since removed himself as a candidate for PM.

Many fear that rather than reestablishing control of Britain to the British people, Brexit could end up tearing it apart.  The House of Lords has already ruled that any decision to leave the EU would need to be approved by the Parliaments of Scotland, Northern Ireland and Wales. The ruling Scottish National Party is unlikely to agree and would savor the opportunity to hold another independence referendum.

Economically, Brexit appears to be an unforced error.  British GDP per capita has grown faster that of Germany and France since Britain joined the EU in 1973 and government projections forecast 0.2% to 0.6% lower growth over 15 years if Britain leaves the EU.  CIBC believes the UK is likely to enter a recession given the negative impact to consumer confidence Brexit will have.

The “leave” crowd believes the opposite, namely the British economy will thrive once it’s free of Europe’s suffocating rules and regulations.  They believe Britain will be able to negotiate favourable trade deals with Europe given the importance of British consumers to the EU’s large export industries.  BMW, for example, exports 11% of its cars to the UK.  It’s true, EU leaders might want to make an example of Britain in order to dissuade other members from opting out, but this won’t come without an economic cost.

MMC3

The real fear, in the markets and in the EU, however, goes well beyond the direct economic cost of Britain leaving the EU, but is centered on the survival of the EU itself.  If the UK can leave, will others follow?  Britain has never fully embraced the European concept and has always identified itself as being “British” as opposed to “European”.

Countries like Germany believe the EU will help prevent future wars and will collectively give Europe a bigger say in the world.  Right or wrong, this isn’t as important to the British people.  Also, Britain has continued to use its own currency, the Pound.

Leaving the EU is going to be a complicated process, but it will be far easier than if Greece or Italy were to leave the EU.   Any country thinking of leaving the Euro-zone will have the additional headache of having to revert back to using their old currency.

MMC4

This does not mean, however, the EU doesn’t have anything to worry about.  The UK might be a deeply divided country, but so is the EU.  Some EU countries want to a closer union, while others believe Brussels already has too much power.

Germany has long maintained that any future pooling of tax revenue will depend on countries adopting deeper structural reforms, which is tough when your youth unemployment rate is over 50% such as it is in Spain and Greece.  Pushing for a tighter integrated core within the EU could actually result in its breakup.

A majority of people in both France and Italy would like to follow Britain’s lead and hold a referendum on EU membership. Both Germany and France share Britain’s concern regarding immigration and are especially unhappy with the EU’s handling of refugees.  Perhaps this common ground could help keep Britain in the EU.

Agreeing to an upper limit on EU immigration for the UK, which is what Prime Minister Cameron wanted earlier in the year, could convince Britons to vote in favour of staying in the EU if a second referendum were conducted.  If EU leaders throw the British a bone rather than taking a hard line in negotiating a Brexit, perhaps support for populist parties in other countries will decline.  Both Germany and France have general elections in 2017, so time is of the essence.

MMC6

Even before Germany and France go to the polls next year, however, there will be an October referendum in Italy that markets are starting to worry about.

Prime Minister Renzi wants to push through some constitutional reforms to streamline the Italian political system and, like the UK’s Prime Minister David Cameron, is gambling on a referendum to give him the mandate to do so.  The reforms are sensible, but the polls are close and there is the chance many will vote against the reforms in order to send a message to the government.  Renzi has vowed to resign if he loses, which would likely result in Italy also facing a general election in 2017.

In the meantime, Italy’s banks are teetering on the brink of insolvency with about €360 million in bad debts, equivalent to about a quarter of Italy’s GDP.  It is estimated €40 billion of capital is needed to shore up bank balance sheets, which the Italian government desperately wants to provide.  Under EU rules, however, public money can’t be used to bail out banks until private sector creditors are bailed in first.  In other words, private holders of bank bonds must see their investments take a hit before government funds come to the rescue.  The problem, however, is ordinary Italian retail investors hold about €250 million in bank debt and would face heavy losses.  Politically, this would hurt Renzi and the ruling Democratic Party, while boosting support for Beppe Grillo and his populist anti-establishment party, the Five Star Movement.  Perhaps the EU needs to throw Italy a bone as well.

Yes, Europe is a mess, and it’s going to remain a mess for many months to come.  Even when Britain chooses a new Prime Minister, there is nothing to say she (it looks like it will be Theresa May) can’t take her time in invoking Article 50 of the Lisbon Treaty, which officially notifies the EU of Britain’s intention to leave the European Union.  After that, they have 2 years to work out the details.

These will likely be tough negotiations and will dominate the attention of many European leaders.  Throw in the issues facing Italy and a Greece in perpetual crisis, and hopes for much needed structural reforms in the Euro-zone take a back seat.

But all this doesn’t impact us in North America and Asia, right?  Unfortunately we live in a connected world, and the capital markets are a glowing example of this.  With the Bank of England indicating a rate cut is likely, it’s no surprise bond yields move sharply lower in June.  As capital around the World made a mad dash for safety, interest rates headed lower in the Euro-zone, as well as in North America and Japan.  10-year U.S. Treasury’s continued their three decade long march lower and in early July traded below 1.4% for the first time ever.  In Canada, 10-year yields are below 1%.

MMC7

Perhaps the most perplexing dash for safety was exhibited by the sharp appreciation in the Japanese Yen.  Even though the real interest rates differential between U.S. and Japanese bonds increased in June as nominal Japanese 10-year bond yields fell more than U.S. 10-year yields, the Japanese Yen appreciated. Japanese government bond yields are now negative up to 20 years, meaning 87% of all outstanding issues trade at yields that provide investors with a negative return if held to maturity.  True, if deflation ends up being more than expected, real returns could still be positive, but more than likely investors aren’t likely to get even a return of capital let alone a return on capital.  Given the recent decline in yields, however, Japanese bonds have been good to foreign investors, providing a year to date return of over 8%.

The rise in the Japanese Yen is a real concern for the Bank of Japan and Prime Minister Abe, however. One of the goals of Abenomics has been to weaken the Yen in order to increase inflation and stimulate economic growth.  The Yen is up over 16% year to date and rose nearly 7% in June alone.  This is not part of the plan.

If the Yen continues to appreciate, the Bank of Japan will be forced to take action, meaning more monetary stimulus.  If this happens, Japanese interest rates could fall even further.

MMC8

Interestingly, while Brexit might be hurting Japan, it might actually be helping China.

The Chinese economy is sputtering.  While the service sector continues to expand, the manufacturing sector is under pressure.  Like Japan, China would like to see their currency move lower.  Unlike Japan, however, China’s Yuan is not a free trading currency but rather is loosely pegged to a basket of currencies.

China has the power to depreciate its currency if it chooses, but knows that any big moves could lead to an outright currency war with other trading nations in the region, as well as pressure from U.S. politicians who feel China manipulates their currency.

There is also the danger of capital fleeing China in anticipation of an even lower currency.  Because of this, past declines in the Yuan have not been well received by the markets and stocks have tended to trade lower.  Brexit, however, has provided a bit of a diversion.  China has been able to let the Yuan decline against the U.S. dollar without traders taking much notice.  In fairness, the Yuan has appreciated against the British Pound and the Euro, but it is down bigtime against the Japanese Yen.

MCC9

Brexit also hasn’t been a bad thing for stocks.  After a brief sell-off after the vote, stocks regrouped and finished the month in positive territory, with both the S&P 500 and S&P/TSX up 0.3% in June.  International exchanges didn’t fare as well, with Japan’s Nikkei 225 down 9.5% and Europe’s STOXX Europe 600 -4.8%. The rally in North America is not very convincing, however.  Defensive sectors like staples and utilities are leading the way, while in Canada, the gold sector has been red hot with many companies up over 100% year to date.

Wall Street loves acronyms, and is calling the current group of defensive market leaders STUB, or staples, telecom, utilities, and bonds.  When asked whether they are worried about valuation, they respond with another acronym, TINA, there is no alternative.  Investors are hungry for yield, and with bond yields so low, dividend paying stocks are in high demand, despite their valuation.  Not in demand are financials.  Low interest rates are killing the banks, as is the prospect of lower investment banking business in Europe given the current uncertainty.

MMC10

Can low interest rates continue to drive the market higher?  With the average total yield (dividend plus stock buybacks) of the S&P 500 presently exceeding that of corporate bonds, stocks would seem to have room to move higher.

Investors will get the same or higher yield with stocks, and still have the potential upside of stock price appreciation.  Why would investors own bonds?  Well, a bond (barring default) guarantees the repayment of principle, a common stock does not.  If corporate earnings decline, stock prices could decline, even if interest rates continue to move lower.  S&P earnings growth has been negative for the past three quarters and is forecast to remain negative in the second quarter.  The energy sector is a big reason why, but even excluding the energy sector, S&P Global Market Intelligence is forecasting earnings will be down 0.4% in Q2.

As mentioned earlier, financials are being hurt by low interest rates, but non-financial profit margins also appear to have topped out and look to be attractive under pressure with higher wages beginning to bite into company profits. Yes, corporate bond yields are lower than stock yields and this should provide support for stock prices, but it hasn’t always been the norm that bond yields exceed stock yields.  Prior to the 1950’s, for example, it was quite common for investors to expect a higher dividend yield on stocks as the risk was perceived to be higher.

MMC11

An economic recession would obviously add to the risk of an earnings decline. Typically, a decline in interest rates is a sign that the economy is at risk of turning over.  In fact one of the best predictors of a recession is an inverted yield curve, meaning long rates decline below short rates.  This hasn’t happened yet, but the yield curve has been flattening.

We believe the decline in long term bond yields is more about what’s happening outside the U.S. than a harbinger of the future direction of the U.S. economy. We still believe U.S. economic growth, while slower than hoped, is moving in the right direction.  In June, private sector economists put the odds of a U.S. recession in the next 12 months at a slightly elevated 21%.  Brexit and general global uncertainty are  headwinds given businesses are reluctant to increase business investment, but concerns of a slowing job market were greatly alleviated in June as the U.S. put 287,000 people back to work.

MMC12

Also looking stronger is the industrial sector, with purchasing manager indexes turning higher in June and the Atlanta Federal Reserve’s GDP Now forecast indicating second quarter GDP could come in at 2.5%.

Consumer confidence also moved higher in June, likely as a result of the healthy job market and signs that wage growth may finally be moving higher.

MMC13

So if the domestic U.S. economy is looking good, is the Federal Reserve going to move ahead with plans to gradually increase interest rates?  I mean, the unemployment rate is under 5% and the Fed funds rate is only 25 basis points!  Again, it’s not about what’s happening in the U.S. but what’s happening in the rest of the world.

After Brexit, Fed funds futures were estimating only a 17% chance of another rate increase this year, with some forecasters believing it could be until 2018 before the Fed acts again.  In early July, futures were actually indicating a there was a 10% chance the Fed cuts rates this year.  If the Fed is on hold for the time being and the U.S. economy continues to slowly recover, stocks could continue to trade higher.  Yes, earnings growth is an issue, but if the U.S. economy avoids a recession, earnings growth may slow but it shouldn’t meaningfully correct.

MMC14

Any other issue to be concerned about?  Oh yeah, there is that Trump guy.  If a vote for Brexit was further evidence of the anti-establishment vote gaining steam and Trump is the anti-establishment candidate, could he become the next President of the United States?  It’s still early days, but the polls are saying no.

Hillary Clinton, having locked up the Democratic nomination, has a double digit lead over the Donald in some polls with nearly two thirds of Americans believing Trump is unqualified to lead the nation.  Both candidates remain extremely unpopular, however, Clinton’s lead narrows considerably when a third candidate is included in the polls.  Hillary is also likely to take a hit once the fallout from the FBI’s final report on her email scandal starts to be reflected in the polls.  The FBI decided not to recommend criminal charges, but they were very critical and many feel Clinton has lied to the American people.

But it’s not just the Presidency that is up for grabs.  The Senate is also in play, with the Republicans in serious jeopardy of losing their majority.  Weak Republican voter turnout could even put the House of Representatives at risk.  A democratically controlled Congress and Clinton presidency might even be worse than a Trump win in November.

Overall, we stick with our view that the impact of either candidate winning will be muted given congress serves as a good safety check.  The rhetoric from Trump and Clinton might be concerning, but it is likely that’s all it will be.  Remember, this is what politicians do, talk.  Or perhaps more to the point in terms of this election, this is what politicians and reality T.V. stars do.

MMC15

The current rally in stocks is being referred to by some as the most hated bull market in history. Equity prices are rising, but it is defensive names that are doing most of the heavy lifting.  Also charging ahead are bond prices and gold, both historically seen as safe haven asset classes.  Bonds are getting so expensive, with yields so low, it is becoming harder and harder to make the case they are still defensive, or safe.  Brexit added to the market’s anxiety and desire for safety in June, and while stocks retreated initially, they quickly recouped their losses and the S&P 500 has gone on to make new all-time highs in July. Investors see no alternative.

How will it all end?   With global growth so low, many are worried the margin of error is razor thin and we could easily slip back into recession.  Brexit, by increasing uncertainty and volatility, increases the odds of this happening.  The best case scenario has U.S. growth continuing to improve and the Fed gradually increasing rates.  The key word here is gradually.  In this scenario, bond returns would be very low, or even negative, but if rates move up very slowly, the coupon rate will mitigate some or all of the interest rate risk.  As for equities, investors would rotate out of defensive dividend payers and into more economically sensitive names, like financials and industrials.  Like the U.S. election, it’s going to be a nail biter.

What did you think of June’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.