Goldilocks Economy in Need of a Bear (or Bull)


Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

Overall, April was a “risk off” month, with most assets classes losing ground.

Bonds were mainly weaker in April. Given the weaker economic numbers coming out of the U.S. (and Canada), we would expect interest rates to remain low. We continue to explore the possibility of adding managers to the NWM Bond Fund, but we do not sense there is an urgent need to gain protection from rising rates.

High yield bonds, mortgages, and preferred shares had a positive April, likely due to narrowing credit spreads. Investors are still struggling to find yield and the result is asset classes like high yield are getting bid up.

Canadian equities were mainly flat with the S&P/TSX losing 0.80% in April (price return not including dividends). Year-to-date, the S&P/TSX is up 2.8% while the Strategic Income Fund is up 5.3%. The TSX was negatively impacted by commodity stocks, particularly gold stocks. This helped the SIF given its underweight gold stocks, which we chose to gain exposure to by way of the NWM Precious Metals Fund.

We continued to reduce our REIT holdings in the SIF and used the proceeds to add to banks. We might look to do a little more, but our REIT position is only around 5% so we are getting close to a good long-term level.

Gold bullion and stocks have suffered over the past few months as investors flee towards the perceived safe haven of the U.S. dollar. Since April, we have been looking to diversify out of certain gold-based funds. The recent performance is not the reason for the move, though it certainly helped solidify our decision.

We also continue to look for opportunities to increase our U.S. holdings, mainly in technology, health care, and industrials.

April in Review

By Rob Edel, CFA

Equity markets were mainly lower in April, with the S&P/TSX losing 0.80% and the S&P500 0.75%. The Dow managed to escape largely unscathed with flat returns for the month.

There were a myriad of issues troubling the markets, but corporate earnings were not at the top of the list. With only about 20% of companies in the S&P 500 left to report, 70% have exceeded estimates, which is higher than the 10-year average of 66%.

This might be a little bit deceiving, however. Estimates were generally reduced earlier in the year, so most analysts expected companies to meet or beat expectations. Over the years, companies have grown wise to the ways of Wall Street and have learned to under-promise and over-deliver.

Earnings growth itself also looked good at first glance, but less so upon further analysis. At 7.6% versus last year, earnings growth was higher than economic growth, but down from 18.2% growth last year.

Also, if Apple were excluded from the analysis, earnings growth plummets to just 3.9%. Still positive, but definitely slower than last year.

With profit margins at historical highs, the next leg up for earnings has to come from economic growth, which has been tepid at best since the end of the great recession.

While we have been growing more optimistic over the past few months that the U.S. economy might be ready to shift into a higher gear, the economy took a step backwards in April with GDP coming in lower than expected and the job market turning in a second consecutive month of anemic growth.

Even manufacturing, which has been leading the U.S. out of the recession, looked weaker in April. Still, most forecasters are more optimistic now than they were at the beginning of the year. Some, in fact, would prefer the economy to weaken even further.

If growth continues to just muddle through, it won’t be strong enough to drive earnings growth higher, but it also won’t be weak enough to compel the Fed to take action and roll out another quantitative easing program. The market likes it when the Federal Reserve eases and has learned to “not fight the Fed.”

Unlike the Goldilocks economy of the mid-to-late 1990’s (not too hot, not too cold) the market would either like the economy to be cold enough to make the Fed take action or hot enough to make investors believe in fairytale endings.

While a slow growth economy might displease some investors, there are alternatives that would be even worse.

Unless some kind of political deal can be reached before the end of the year, the U.S. faces tax increases and spending cuts that could lower GDP next year by almost 4%. Under this scenario, even another quantitative easing program by the Federal Reserve would be unlikely to prevent the economy from slipping into recession.

Alternatively, with inflation remaining high, some investors are concerned the Fed could actually tighten monetary policy and interest rates could rise earlier than expected.

Already, seven of seventeen Federal Reserve officials believe short-term rates will need to increase to 2% by the end of 2014, while only four (Fed Chairman Ben Bernanke presumably being one of them) believe they will remain unchanged.

In January, only five officials believed rates would need to rise to 2% by the end of 2014. It’s a balancing act. Our guess is the Fed will roll out another QE program if the equity markets take another dramatic turn for the worse or if the growth in the job market loses steam. Otherwise, the Goldilocks economy (2012 version) is probably not a bad place to be.

Don’t get us wrong, if the economy strengthens meaningfully, the Fed will tighten; we just see that as unlikely in the short-to-medium term. Count us in with the four Fed officials who believe rates will remain at zero until the end of 2014.

For this month, anyways.

While the U.S. weighs the odds of more monetary stimulus versus higher interest rates, Europe has their own balancing act to manage.

Hitting budget deficit targets and reinforcing austerity and social reforms are necessary in order to maintain investor confidence, but it’s tough to hit deficit targets when economies are contracting and big spending cuts mean certain recession, or even depression. Austerity can actually be counter-productive in reducing deficits, as it can cause tax revenue to plummet.

Southern European economies are under tremendous pressure. The unemployment rate in Spain hit 24.4% in Q1 and topped 50% for workers less than 25 years of age. Same in Greece, where the economy is expected to contract 5% this year. Italy expects its economy to contract 1.2% and recently joined Spain in backing off on previously announced budget deficit targets.

Most of Europe, in fact, has slipped into recession.

In recent elections, pro-growth (meaning anti-austerity) candidates have been gaining power. In France, a Socialist became President for the first time in 17 years when François Hollande defeated Conservative Nicholas Sarkozy.

In Greece, the two main incumbent parties saw their support plummet, leaving a dysfunctional group of parties from the fringe right and left with more than 60% of the popular vote. Since it is likely no party will be able to form a workable government, a new election will inevitably be needed.

While not the first time Greece has been in this position, it is uncertain whether a new election would solve anything, at least not for the good anyways. The Coalition of the Radical Left, or Syriza Party, which saw its vote more than triple to 16.8%, is thought to have gained even more popularity since the election.

Many fear another election (or the one after that) would leave Syriza in power, after which they would repudiate the austerity commitment made by the last Greek government and exit the Euro. With this scenario clearly in mind, the ECB is withholding a portion of the recent bailout package until further clarity can be attained.

From the Greek perspective, with an unemployment over 20%, GDP growth of -5% and bond yields over 24%, how much worse could it get if they left the Euro? The ECB is trying hard to convince Greece that it could get much worse, though in the short term the markets are concerned that it would be much worse for the rest of Europe.

No one seems to be immune from the political upheaval sweeping Europe with even Germany suffering some electoral backlash.

Chancellor Merkel’s ruling Christian Democrats recently lost ground in a state election to opponents touting a growth platform. Since 2008, in fact, a dozen Euro-zone governments have fallen while wielding the sword of austerity and reform. The people are speaking and politicians will have to listen or risk joining Monsieur Sarkozy in retirement.

The result will likely be a little give and take, meaning Germany will give and the rest of Europe will take. Germany will hold firm on the recently agreed Fiscal Compact with its emphasis on budget discipline, but countries will be given more leeway in regards to when targets must be hit.

Germany is also likely to accept a slightly higher inflation rate in order to accommodate their weaker neighbors. Fiscal discipline is important, but not if it leads to political and social upheaval.

Europe needs to follow Germany’s lead and commit to reforms that will result in a more competitive labour force and economy. It will take time, however, and inflicting too much pain upfront will result in countries turning their back on the Euro.

Nobody gains from shelving the Euro, especially Germany. We still think the Euro survives, but Greece’s participation is probably a jump ball (50/50) right now.

The U.S. Economy

The U.S. economy took a step backwards in April as economic growth in the first quarter was not as strong as hoped with GDP growing an anemic 2.2%.

And this was with the benefit of a warmer than normal winter.

Consumer spending was strong, but non-residential fixed investment, which is basically everything else, fell for the first time in two years in Q1. The fear is that manufacturing may have benefitted from inventory restocking after the recession, but the economy is not growing fast enough to entice companies to make further capital investments.

A similar situation might be playing out with the consumer, with the recent surge in spending due to a bounce back from depressed levels that won’t be sustained given the need for consumers to continue to de-lever.

While we do not think economic growth is set to surge, we do think it’s too early to throw in the towel and worry about recession.

Yes, manufacturing slowed in April, but it is still growing. A warm winter probably shifted a little demand to February and March from April (though not according to Q1 GDP). We still have hopes the recovery in manufacturing is more secular than cyclical.

A recent Boston Consulting Group survey of 106 large U.S. manufacturers, in fact, found 37% plan or are actively considering shifting production back to the U.S. from China and 70% believe Chinese production is not as cheap as originally thought.

Even European manufacturers are considering shifting operations to the U.S. in order to take advantage of the cheap dollar and higher productivity.

The slowdown in economic growth was evident in the job market in April, as only 115,000 new jobs were added. Again: still positive, but below par.

Since bottoming in February 2010, the U.S. has added 3.7 million new jobs, or about 134,000 per month. More significantly, an average of 197,000 have been added over the past six months. The unemployment rate fell, but only because 342,000 workers left the U.S. Labor market.

The good news is that employment in February and March was revised a combined 53,000 higher and there is a decent chance April’s number will also be revised higher.

Inflation eased slightly in March, but remains elevated.

Given the slowdown in economic growth, this presents a problem for policy makers, particularly if growth continues to slow. Further monetary stimulus could risk driving the inflation rate even higher.

While the Federal Reserve believes the elevated inflation rate is temporary and inflation is likely to continue moving lower given the presence of excess capacity in the economy, they have been saying this since early 2011 and have consistently underestimated inflation, mainly due to high oil prices.

With the International Energy Agency recently stating their belief that tightness in the oil market has started to reverse for the first time in two years, there is hope the Fed may finally be right and prices should stabilize or even start to decline.

Oil inventories were up 1.2 million barrels per day in the first quarter with OPEC production up almost 1.4 million barrels per day over the past six months.

While air strikes against Iranian nuclear facilities and the resulting impact on tanker traffic through the Strait of Hormuz remains a concern and could result in a spike in oil prices, we sense the threat is lessening. There also seems to a diminished political appetite in both Israel and Iran for military action.

Of course this could change very quickly.

 

Consumer confidence declined slightly in April, but the decrease was marginal.

We expected retail sales to be weak in April due to an early Easter (it fell in March this year versus April last year) and they didn’t (or more, accurately, did) disappoint.

April same store sales were lower than expected, turning in their weakest performance in a year and a half. Even if one combines March and April together, you still only get 4.5% growth versus 6.4% the previous two months.

We suspect a warmer than normal winter resulted in consumers buying goods in February and March that would normally have been purchased in April. As mentioned earlier, consumer spending was one of the only bright spots for the economy in Q1 and some consolidation or slowdown is not unexpected.

We are concerned, however, with the trend of the personal savings rate. While it moved up ever so slightly in March, it has been moving lower the past several months, reflecting an increase in retail sales in the face of stagnant income growth.

This is not sustainable as consumers still have balance sheet repair work left to do. Continued progress in the employment market and wage growth will ultimately determine the pace of gains in retail sales and if April is any indication, this does not bode well for future retail sales.

A mixed month for the housing market. Sales were down slightly from last month, but prices look to be bottoming.

While there is still concern over the impact of the estimated 450,000 bank-owned properties waiting to hit the market – not to mention the 2 million more homes in the process of being foreclosed and the 1.7 million homes where borrowers haven’t made a mortgage payment in more than 90 days – we are still hopeful investors will step in and clear the market.

Prices are cheap and a reasonable income can be generated from renting them out. The Census Department estimates the vacancy rate for rental units fell to 8.8% in Q1, the lowest level since 2002. The median rent increased to $721 per month, the highest level since 2006.

Builders are starting to take notice and new construction is beginning to normalize. There is still have a long way to go, but we are hopeful America has seen the bottom in their housing market.

Lower oil imports and trade with China account for much of the decline in the trade deficit.

We suspect seasonality played a large role in the decline of the trade deficit with China (Chinese New Year in February) and thus we will have to wait until March to see if a more sustainable trend can be determined.

The Canadian Economy

Another disappointing month for GDP growth in February.

The first quarter is shaping up to be well below forecast and Q2 isn’t looking much better with mixed manufacturing indicators in April. While both the RBC and Ivey purchasing manager indexes were above 50 and thus indicating expansion, the Ivey PMI was down significantly from March.

Canada is benefitting from a rejuvenated North American auto industry but we fear some of the recent auto demand could be the result of a short term catch up following the recession and Japanese Tsunami.

While the strong Canadian dollar continues to provide a head wind for manufacturing in Canada, the strength of the U.S. economy will be the ultimate driver for growth. Based on April’s result, we are less confident in this than we were last month.

Having said that, in April Canada delivered better-than-expected job growth for the second consecutive month. 140,500 new jobs for March and April combined is the second largest 2-month increase since 1981.

Quality in April was also very high, with 43,900 new full-time positions and 85,800 new positions coming from the private sector (which means the government sector lost jobs).

The manufacturing industry managed to add 24,000 jobs and is flat for the year, a good result given pressure being inflicted on the Ontario heartland from the strong dollar. We suspect the resurgent auto industry is helping out.

Also showing strength was the construction industry, adding 25,000 jobs. With more and more talk of a condo bubble in Vancouver and Toronto, we are a little less enthusiastic about this gain.

The unemployment rate ticked up a notch, but only because more people were looking for work. If Canada’s unemployment rate were calculated using the same methodology as the number reported in the U.S. (an apples to apples comparison), Canada’s unemployment rate would actually come in at 6.4% versus the reported 7.3% and much lower than the 8.1% reported by the U.S.

About the only negative we could find with the job market in April was youth unemployment, which remains high at 13.9%. The unemployment rate in Ontario also deteriorated, increasing to 7.8% from 7.4%.

This is important, given Ontario – or more specifically, Toronto – is the center of the universe and high unemployment in this region could have potential implications for monetary and fiscal policy.

Inflation moderated somewhat in March, but continues to track above the desired 2% level.

In conjunction with the Bank of Canada’s firmer forecast for both growth (despite the poor January and February GDP numbers, B of C Governor Mark Carney increased his 2012 GDP growth forecast to 2.4% from 2.1%) and inflation, many believe an increase in the Bank of Canada rate could happen before the end of the year.

Presently, the markets are pricing in a 50% probability that rates increase by September and almost 100% probability they increase by the end of the year. This is quite a different message than that of the Federal Reserve, which never passes up the opportunity to reiterate their plans to keep rates at 0% until at least the end of 2014.

This, and the fact the Canadian dollar is heavily influenced by energy prices, has resulted in a stronger Canadian dollar.

Consumer confidence declined in April, giving up some of the strong gains seen in March. Retail sales were also lower, mainly due to slower auto sales. Excluding auto, sales were actually up 0.5%.

Canadians have still not embraced the global de-leveraging trend. Equifax Canada estimates consumer debt ex-mortgages grew 3.4% in Q1 with new loans increasing 1%. Auto finance was the big driver, increasing 10% versus last year.

The housing market remains strong, though Vancouver is beginning to show some weakness.

The average cost of a home in Vancouver declined 3.1% versus last year and sales are off 22.3% in the first quarter. The Toronto market continues to move higher, with average prices up 10% in March.

Canada’s trade balance remained positive in February, though just barely. Lower auto and energy exports were the main culprits.

Canada continues to out-perform the global economy, at least from a jobs perspective. Make no mistake, however, if the U.S. continues to slow, so will Canada. Throw in a disintegrating European economy and trouble in China and it’s hard to feel too confident. The Bank of Canada would like to raise rates, but will only do so if the global economy stabilizes.


What did you think of April’s market activity?  Let us know in the comments below!