April In Review: The Bulls And The Bears, Who’s Right?


By Rob Edel, CFA

Highlights This Month

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Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 0.3% in the month of April. The NWM Core Portfolio Fund is managed using similar weights as our model portfolio and is comprised entirely of Nicola Wealth Pooled Funds and Limited Partnerships. Actual client returns will vary depending on specific client situations and asset mixes.

Both Canadian and U.S. yield curves shifted higher last month, with the Canadian curve also steepening as the nearly 22 basis point rise in 10-year yields outpaced the increase in short term 2-year yields by 10 basis points. As for U.S. yields, 2-year and 10-year rates moved up a nearly identical 22 basis points. Though higher yields provided a headwind for returns in the NWM Bond Fund last month, favorable results in our credit oriented funds resulted in an overall gain of 0.3% in April.

The NWM High Yield Bond Fund gained 0.2% in April, compared to the Bank of America Merrill Lynch U.S. High Yield Index +0.7%. Year-to-date, the fund is +1.5% compared to -0.3% for the Index. All our high yield managers reported positive monthly performance in April, but a weaker U.S. dollar dragged down the fund’s return. The fund currently has 40% U.S. dollar exposure.

The NWM Global Bond Fund was -1.0% in April, with a 0.3% rise in the Canadian dollar weighing on returns. Pressure on emerging market debt and currencies also hurt performance last month.

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 last month. 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 NWM Primary Mortgage Fund and 5.6% for the NWM Balanced Mortgage Fund. The NWM Primary Mortgage Fund ended the month with negative cash of $4.5 million, or 2.8% (we utilized our short term credit lines). The NWM Balanced Mortgage Fund ended the month with $32.5 million in cash, or 6.7%.

The NWM Preferred Share Fund returned -0.3% for the month while the BMO Laddered Preferred Share Index ETF returned -0.5%. The preferred market weakened during the month despite the 5-year Government of Canada yields moving 16 basis points higher. There were no new issues during the month; however, we increased our positions in Brookfield Asset Management, Brookfield Properties, ECN Capital, and Artis REIT as weakness in the names provided attractive opportunities to build our positions.

Canadian equities were stronger in April with the S&P/TSX +1.8%, while the NWM Canadian Equity Income Fund returned +1.1%. Energy was strong with the iShares S&P/TSX Capped Energy (no pipelines in this ETF) +12% for the month. We are underweight E&P, which was a major source of our underperformance versus the index. Our consumer discretionary overweight helped performances in April, while our consumer staples positions (ATD/B and BCB) were weak. We added new positions in Inferfor and sold West Fraser Timber. Top contributors to performance were Canadian Natural Resources, Whitecap, and Great Canadian Gaming. Largest detractors were Spin Master, Dollarama, and Air Canada. Covered call writing is up to 24% of the portfolio. The target yield on the portfolio (including covered call writing) is 6.5%.

The NWM Canadian Tactical High Income Fund returned +0.5% last month. The main reason for relative under performance was also due to being underweight in energy (3.5% target weight vs 19.5% benchmark). We are still taking a defensive strategy with the fund in trying to get mid-to-high single digit annualized option premium while providing good downside protection. Last month we were able to earn even higher option premiums and added two new names, Transcontinental (12% premiums; 6.58% downside protection) and West Fraser Timber (26% premium; 9.37% downside protection).

The NWM Global Equity Fund was flat last month vs +0.5% for the benchmark, the MSCI ACWI Index (all in CAD). Our exposure to Europe through NWM EAFE Quant and ValueInvest was accretive to performance; however, this was more than offset from our exposure to emerging markets through BMO Asian Growth & Income. Regional returns (CAD) in order of performance: MSCI Europe Index was up 2.3%; MSCI AC Asia Pacific Index was up +0.4%; S&P500 was down -0.2%; MSCI EM Index was down -0.9%.

Manager returns, in order of performance: NWM EAFE Quant +1.4%, ValueInvest +0.7%, C Worldwide +0.1%, Edgepoint 0.0%, Lazard Global Small Cap Equity -0.7%, Matthews Asian Growth & Income -1.1%. NWM EAFE Quant was accretive to performance last month as the fund invests only in developed markets in Europe, Australasia, and the Far East, which outperformed U.S. and emerging markets. ValueInvest’s slight outperformance came from region and stock selection, in particular their exposure to Europe, and consumer staples names Ahold Delhaize and Hormel, despite being overweight in the consumer staples sector (which detracted from performance). C Worldwide’s overweight in Asia-Pac and emerging market regions and the IT sector were drags on performance. In terms of stock selection, exposure to a Taiwanese semiconductor company, as well as tobacco, more than offset gains from Royal Dutch Shell and Visa. Edgepoint was flat as they were overweight in the U.S. when the S&P500 was down slightly; in terms of stock selection, Affiliated Managers Group and TE Connectivity detracted from performance, which more than offset gains from positions in US Industrials Wabtec and CSX. Lazard benefitted from being underweight in the U.S. and overweight in the UK, however this was more than offset by sector exposures, as the manager was overweight IT and Industrials – sectors that lagged; and underweight utility and energy sectors, sectors which were strong.

The NWM U.S. Equity Income Fund was also flat in April, versus a 0.4% increase in the S&P500. Relative performance was driven by what we didn’t own: not owning internet retailers such as Amazon more than offset positive performance from not owning tobacco and being underweight in the semiconductors industry. In terms of specific stocks, energy names Valero and EOG helped performance, but this was more than offset by owning L3 Technologies, Crown Castle, and Comcast. We added a new name to the portfolio, Westrock, a corrugated and consumer packaging company. We trimmed our positions in retailers Walmart, Home Depot and Costco, as well as EOG; and added to Vulcan Materials, Carnival Cruises, Crown Castle, and NVidia.

The NWM U.S. Tactical High Income Fund’s performance was +0.8% during the month. The fund’s outperformance was due to being underweight industrials and strong stock selection. Market volatility dropped 32% during the month, but this did not impact the option writing strategy; on average the fund generated 12% put option premiums with 10% downside protection. Two new names where added: Hasbro and Waste Management; both had close to 12% annualize put option premiums.

The NWM Real Estate Fund was +1.6% for the month of April vs. the iShares (XRE) -0.1%. The fund was helped out by strong performance from Pure Multi-Family REIT (RUF-U) +17% in April. RUF-U was presented with a conditional, unsolicited offer from Electra America to acquire 100% of the units of the REIT for $7.59 per unit (USD) which equates to an implied cap rate in the low 5% range. The offer was deemed inadequate by the special committee. Now the REIT announced that they are undergoing a strategic review to evaluate its potential sale. . We have a 6% allocation to RUF-U, which represents our largest publicly traded stock position (16% allocation if we are just looking at the publicly traded REITs).

We report our internal hard asset real estate Limited Partnerships in this report with a one month lag. As of April 30th, March performance for SPIRE Real Estate Limited Partnership was +1.7%, SPIRE U.S. Limited Partnership -0.1% (in US$’s), and SPIRE Value Add +1.3%.

The NWM Alternative Strategies Fund was up +0.2 in April (these are estimates and can’t be confirmed until later in the month) with Winton +0.9% and Millenium -0.5%. Of our other alternative managers, RP Debt Opportunities was +0.6%, Apollo Offshore Credit Strategies Fund Ltd. +0.3%, and Verition International Multi-Strategy Fund Ltd. +0.3% and Polar North Pole Multi-Strategy was flat. Precious metals stocks were stronger last month with the NWM Precious Metals Fund +1.5% while gold bullion declined 1.1% in Canadian dollar terms.

April in Review

Overall market returns in April belie the underlying conflict and volatility experienced by traders and investors last month. The S&P500 ended the month nearly 0.4% in U.S. dollar terms (down 0.2% when translated back into Canadian dollars,) but experienced five intraday trading sessions with declines in excess of 1%, one more than all of 2017. Canadian stocks fared better, increasing 1.8%, and endured far less volatility. Market action in other asset classes, like bonds, commodities and credit, also experienced less price volatility than U.S. stocks, but the direction of their moves continue to highlight the battle being waged between market bulls and bears. After hitting an all-time high January 26th and falling more than 10% to the downside, stocks have been unable to recoup their losses and signal an official conclusion to the current market correction. According to the Leuthold Group, this is longer than normal and could be a sign the bull market is in trouble and markets have changed. We are not convinced, and will use the rest of this month’s commentary to explore the pros and cons of the arguments being waged by the bulls and bears.

An extended market correction can definitely turn into a bear market, but this correction isn’t exhibiting traits we would expect to see before a bear market. Late cycle stocks and value styles tend to outperform before bear markets, and that’s not happening, yet. The trend of growth stocks outperforming value is still intact and the energy and material sectors have failed to gain on the overall market as they historically have in mature business cycles where an overheating economy starts bidding up the price of commodities. We concede energy has started to outperform with crude oil prices moving higher, but this is as much about geopolitics as it is about demand. Market breadth also continues to be quite healthy. Bear markets are typically preceded by rallies fueled by fewer stocks as deteriorating growth makes it harder to find companies with good fundamentals. This is not the case currently, as market strength is pretty evenly distributed.

Earnings growth is actually one of the big stories this year. A stronger global economy and favorable tax reform has resulted in more companies reporting stronger growth. The combination of higher earnings and lower stock prices has had a positive impact on valuations, with price/earnings back down to 2016 levels. At over 16 times forward earnings however, even with S&P500 earnings for the first quarter expected to rise 17% year over year, the Wall Street Journal’s Market Data Group estimates an additional 28% growth would be required before trailing price/earnings multiples returned to its 10-year average.

The bears would also contend earnings have peaked and most of the gains in the market occurred after the U.S. overhauled its tax code late last year and is already discounted by the market. This leaves investors left asking, now what? Or so say the bears (and even some of the bulls, according to the cartoon below).

The main concern implied by the peak earnings argument is we are nearing the end of the business cycle. When polled, more economists believe the risk to their estimates for economic growth is to the downside versus the upside, and economic surprise indexes have started to turn lower. According to the IMF, growth in the developed world continues to move higher, but there are signs the rate of growth has slowed.

This is especially the case in Europe, with purchasing manager indexes declining and indicating growth in the Eurozone industrial economy is cooling. Europe was surprised at the upside last year however, so some slowing can be expected. The Eurozone is still expected to have positive growth, just not as much as last year.

As for the U.S., first quarter GDP growth was a modest 2.3%. This was higher than the 1.8% estimate, however, it is typically weak due to seasonality. The key for growth going forward is business investment. Companies have been extremely frugal since the financial crisis and have opted to use their spare cash to buy back shares and pay dividends rather than invest in their business to either drive growth or improve efficiency. In order for the economy to keep growing without overheating and creating inflation, productivity needs to move higher, which requires business investment. In the first quarter, it appeared new orders for non-defense capital goods was weak, but this number doesn’t include technology firms, who have been ramping up spending on things like data centers, servers, and communication equipment. With companies able to fully expense business investment for the next five years, they have a huge incentive to increase capital expenditures. Business investment is one of the key economic numbers we will be watching in order to gauge how much longer the current business cycle can extend. It could be the determining factor in who is right, the bulls or the bears.

Indicators to watch to determine if a properly deployed business investment is enabling the economy to continue to grow without overheating are 10-year bond yields. One of the market’s main concerns last month were the belief that higher U.S. growth would be matched by rising inflation, which is why 10-year U.S. government bond yields were on the move again in April, and topped 3% for the first time since late 2013 (though they closed the month slightly below 3% at 2.95%). It’s just a number, but the market likes to fixate on round easy to remember figures. Higher 10-year yields precipitated the market correction earlier in the year and the likelihood that it will move even higher has again spooked investors. JP Morgan CEO Jamie Dimon and Franklin Templeton Bond Chief Michael Hasenstab, who is one of the managers of our Global Bond Fund, believe the 10-year bonds could hit 4% this year. Perhaps an even greater threat to the market, however, is 2-year yields, which have been outpacing the rise in 10-year yields this year and closed the month at nearly 2.5%, its highest level since 2008, and also a nice round number we would suggest. Not only does a safe 2.5% yield start to look pretty good as a proxy for holding cash, but it is also fairly competitive with most corporate dividend yields.

Higher short term rates also mean the yield curve is in greater jeopardy of inverting, which has historically been a near perfect indicator for a recession. However, a flattening yield curve, which is what we have experienced so far, is actually a good environment for risk assets in that it is indicative of a healthy economy with a still accommodative monetary policy. The problem is in order to invert, the yield curve invariably has to flatten first. The length of the flattening cycle is the key. We think it will be longer than the market thinks. The Fed and other central banks are going to tighten, but they will likely err on the side of caution and do so very slowly. Even at their peak, Fed funds are forecast to struggle to reach the 3% level.

The speed and magnitude of central bank tightening will be dependent on inflation. Since the financial crisis, the Fed has consistently over estimated inflation. Finally, however, CPI appears to be firming and reaching the Fed’s 2% target level. No longer is the Fed worried about downside risk to inflation as deflation fears have receded, which is bullish, but if it keeps increasing and forces the Fed to tighten more aggressively, this is very bearish and will bring about the end of the business cycle.

Wage growth remains to be the key, and with the unemployment rate hitting 3.9% in April, it’s hard to see a scenario where wage growth doesn’t continue to move higher. While we believe wage inflation will continue to track higher, we don’t see it spiking significantly higher in the near term. Another concern in the near term for inflation is oil prices, which has been moving higher and have historically exhibited a strong correlation with 10-year bond yields.

As mentioned earlier, the story for oil is not just a demand story. Concerns over supply have also played a role. In fact a Bloomberg Economics model suggests 50% of the increase in crude this year is due to concerns over future supply shocks. A stronger global economy is good for demand and this has helped move prices higher, but so has declining production from Venezuela, which has more than offset those of Saudi Arabia in absolute terms and helped make OPEC look good, despite increased production from U.S. shale. In addition to further cuts from Venezuela, the U.S. pulling out of the Iran nuclear accord in early May could reduce supply from Iran, further lifting oil prices. The bears would highlight that this means inflation is rising and will likely take yields with it. Even worse, Oxford Economics believes if WTI stays at current levels, U.S. GDP growth could lose half the expected 0.7% boost from the recent tax cuts given the extra cost to consumers at the pump. There’s likely a limit to how high oil can go, however. Even though Saudi Arabia has expressed a desire to see oil above $80 a barrel, they would likely step up production if prices spiked meaningfully higher, as would U.S. producers. The bears concerns are acknowledged, but we don’t see a material boost to inflation from higher oil prices. Just as likely, would be a reduction in consumer spending due to higher gasoline prices, which would potentially be deflationary, as it would slow economic growth.

Higher oil prices and a lower U.S. dollar usually go hand in hand, but the greenback has bucked (excuse the pun) the trend and strengthened last month, erasing all its losses for the year. But, why the turn around? For us, we are less puzzled by why the dollar has rallied than why it had been weakening earlier. Concern over America’s growing budget deficit is a commonly used explanation. Over the next five years, the U.S. is projected to be one of the few countries to experience a higher debt to GDP ratio thanks to the impact an aging population will have on future entitlement spending levels and the recent tax cuts. Someone’s got to buy all the bonds issued to pay for these deficits, and foreign demand for U.S. government paper has been trending lower. While this could be an issue down the road, we don’t think it’s a problem right now. The U.S. is still the world’s reserve currency and a growing global economy should result in a growing demand for U.S. government debt and U.S. dollars.

Could it be the threat of trade wars, especially with China, was putting the dollar under pressure? Sure, this is bound to keep investors on edge, but wouldn’t this cause the dollar to strengthen against other currencies given the U.S. is less dependent on trade? The most logical explanation for the dollar weakening was that economic growth in Europe and Japan would lead to tighter monetary policy in these countries and shrink the interest rate gap with U.S. government bonds. While this will happen eventually, it hasn’t yet, and with U.S. 10-year government bond yields hitting 3% last month and growth in Europe slowing, the spread has continued to expand. According to DWS, the spread between 10-year U.S. treasury and 10-year German bunds is at its widest level since 1989. Given this widening spread, the demise of the U.S. dollar was a little premature and the current rally could have legs.

Quite frankly, determining the fair value of a currency and what’s causing it to appreciate or depreciate is hard, especially in the short term. There are just too many factors coming into play, with many of them less than transparent to the general market. Currencies are important in determining the direction of the economy and markets, however. A stronger dollar, for example, should offset some of the inflationary impact of higher oil prices given it will take less dollars to buy the same amount of imported goods. This is bullish. A stronger dollar, however, is also negative for corporate America and the competitiveness of their exports, and it’s also very bearish for emerging market economies that have borrowed heavily in U.S. dollars. Not only does a strong dollar hurt countries that have borrowed in dollars, it also increases the cost of their imports, even if they aren’t directly trading with the U.S. companies. According to Harvard economist Gita Gopinarth, about 40% of world trade is invoiced in dollars, despite the fact the U.S.’s share of global trade is only about 10%.

The dollar and low global yields provide a ceiling for U.S. yields. If the spread between U.S. and Eurozone yields expands too much, the dollar rally would gain steam. Not only would this be bad for the U.S. economy, but it would be bad for emerging market economies and could create a global financial crisis. It’s another reason the Federal Reserve will proceed with caution in raising rates. This provides a nice environment for investors. Growth is strong and driving earnings higher, but not too strong that inflation and higher interest rates will bring an abrupt end to the business cycle and cause a recession. Investment spending and the resulting increases in productivity could extend the cycle even longer. There is always a chance an exogenous supply shock like lower oil exports from Iran or Venezuela could surprise the market, but oil’s impact on U.S. economy is more balanced now that it is also a major producer as well as consumer of crude. Markets will likely remain choppy, and could trade sideways until mid-term U.S. elections in November. This is normal given the uncertainty preceding any mid-term election. Berkley’s Terry Marsh and the University of Queensland’s Kam Fong Chan have found the Dow Jones Industrial Average has historically produced only an annualized 1.4% gain the six months preceding mid-term elections versus a nearly 22% gain after. President Trump, of course has taken uncertainty to a whole new level. With staff turnover, threats of impeachment, and a potential grand jury testimony, the mid-term elections will just add to the existing uncertainty investors and companies will have to endure this year. Despite this, however, we’ll still run with the bulls, at least for now.

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. Returns are quoted net of fund/LP expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your NWM advisor for advice based on your unique circumstances. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.