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American Idle and the Eurozone X Factor

Monthly Market Commentary | July 2012

Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

If we had to choose, we’d say that overall, July was a “risk on” month – but it was close.

Bonds were modestly higher and high yield bonds had another positive month in July with the NWM High Yield Bond Fund up 1.0%.  The NWM Global Bond Fund gained 0.9% in July; a pretty good result given the Canadian dollar was up over 1% versus the U.S. dollar during the month.

Preferred shares were up in July, with the NWM Preferred Share Fund gaining 0.8%.  We are running a bit more cash in the account and will opportunistically look to deploy it over the next few weeks.

Canadian equities were higher in July with the S&P/TSX gaining 0.8% (total return, including dividends) while the NWM Strategic Income Fund (SIF) only managed a 0.3% return.  We had a large percentage of our call options expire in July and we used this as an opportunity to increase the covered call exposure in the portfolio.  The running yield in the SIF is approximately 6.75%.

We initiated a position in Ritchie Brothers in the beginning of August as the recent price decline enabled us to establish a position in a world class company with attractive growth prospects.  We wrote options on half the position at very attractive yields (annualized 30% over 46 days).

The strong Canadian dollar made it tough on global equities in July.  The NWM Global Equity Fund lost 1.0% while the MSCI index was off 0.3%.  We are particularly pleased with Carnegie, who was up 0.9% in July.

The NWM Alternative Strategy Fund was up 0.5% (estimated) in July.  We have added two new funds to the Alternative Strategies Fund: Brevan Howard and Millennium.  Brevan Howard is a macro fund while Millennium is a multi-strategy fund.

JULY IN REVIEW

By Rob Edel, CFA

July was smoking hot! 

No, not the equity markets.  They were actually pretty mild, with the S&P/TSX gaining 0.8% and the S&P 500 and Dow rising 1.4% and 1.2% respectively.

It was thermometers that were soaring, with the U.S. recording the highest average temperature in the lower 48 states since records began being kept in 1895.  Ominously, one had to go back to July 1936, during the height of the depression and infamous “dust bowl,” to find the previous record high.

Equity markets, while nowhere near the despair of the “Dirty ‘30s,” have been unusually quiet.  Trading volume, already low in 2012, fell off the map in early August and was 45% lower than the same period last year.  Perhaps it was too hot to trade?

We suspect there are a few other factors keeping traders on the sidelines, namely earnings, Europe, and China.

With corporate America winding down its second quarter reporting season, S&P Capital IQ recently reported that a healthy two-thirds of companies have so far managed to top expectations.  Unfortunately, this is mainly because most had previously lowered expectations.

In October 2011, analysts were looking for earnings to grow 8% in Q2, but by early July they had lowered their forecasts to -0.9%.  While earnings have come in considerably higher (+13.6% with 195 of the S&P’s 500 companies reporting), most of the gains have come from cost-cutting as revenue increased a mere 3.9%.

The future is not looking any brighter either. According to Thomson Reuters, earlier in the year analysts were forecasting earnings for the S&P 500 would increase 10% in 2012, but are now looking for only 5% growth.

Third quarter earnings are actually expected to shrink 0.4%, which would be the first quarterly decline in earnings since the recession ended.

With earnings clearly decelerating, it’s no wonder companies are becoming more defensive.  The Federal Reserve estimates corporate America is sitting on liquid assets of $1.74-trillion as of the end of March, and Standard & Poor’s Howard Silverblatt estimates S&P 500 companies have squirreled away 70 weeks’ worth of net operating cash – a huge cushion.

Mirroring this nervousness, investors have been reducing their exposure to cyclical stocks and bidding up the value of traditionally defensive sectors.  According to Morgan Stanley’s Adam Parker, at 15 times forward earnings, defensive stocks are currently trading at decade-high valuations compared to their cyclical peers.

Alliance-Bernstein chief market strategist Vadim Zlotnikov recently compared the relative valuation of defensive stocks to the technology bubble of the late 1990’s and further pointed to the 25% premium investors are willing to shell out for dividend paying stocks versus non-dividend paying stocks as evidence of the crowed trade currently favoring defensive names.

It will end sometime, but, like low interest rates, it could go on for longer than people think.

Of course, a big reason for the decline in corporate earnings and the shift to defensive stocks by investors is uncertainty over the fate of Europe.

Not only are the 27 countries of the European Union the largest economy of the world, but they also account for 20% of U.S. exports and an estimated 17% of profits for S&P 500 companies.  And Europe is in trouble.

Manufacturing activity for the 17-member Eurozone is contracting, as evidenced by the July PMI index reading of 44.1 (anything below 50 indicates the manufacturing sector is contracting), the weakest since July 2009.  Even stalwart Germany came in at a disappointing 47.3 with industrial output in Germany declining 0.3% in June.

What about Spain and Italy? Well, it gets a lot worse.  Industrial production declined 6.9% in Spain and 8.2% in Italy.  Industrial production in Greece actually rose 0.3%, the first increase since before the financial crisis.

But don’t get too excited.  Greece’s unemployment rate hit a record 23.1% in May with the youth unemployment rate (15 to 24 years old) coming in at a shocking 54.9%.

With investors fleeing Spanish and Italian debt, European Central Bank president Mario Draghi went “all in” by stating in late July the ECB would “do whatever it takes to save the Euro” and further dared non-believers by saying “believe me, it will be enough.”

While Draghi hasn’t released specific details of his plans, it is likely any country seeking bond market relief will have to make an official appeal to the Eurozone’s rescue fund, and fiscal and structural reforms will be part of the deal.

The market took the statement to mean the ECB would drive Italian and Spanish bond yields lower using the full firepower of the central bank’s balance sheet.  The German Bundesbank is defiantly against such a move, but status quo is increasingly a non-option if the Euro is to survive.

10-year bond yields above 7% are generally deemed to be the signal that a country has been shut out of the public debt markets and needs a bailout.  Spanish 10-year bonds were trading well above this level in July and Italian debt looked to be heading on the same path.

The hope is lower bond yields will buy Spain some time to let reforms take hold.  Draghi has put his and the ECB’s reputation on the line.  If he does not come up with a credible plan, 10-year Spanish and Italian debt yields will soar.

So far the jury is out, as Draghi’s comments have driven rates in Spain below 7% – but only barely.

Can the ECB buy Spain enough time to regain the confidence of investors?  Well, if Spain follows the path of Ireland they can.

Industrial production in Ireland was up 10.5% in June and the National Treasury Management Agency (Irish central bank) recently raised over $5-billion of 5- and 8-year money from the public markets.

If there is a roadmap for success in Europe, it just might be Ireland.  For every Ireland, however, there is a Greece, where there is speculation that another debt write down might be needed.  The Greek economy is contracting faster than expected, requiring additional austerity measures in order to hit deficit targets.

There is growing fear that the current political reality in Greece will prevent this from happening and could result in the ECB deciding not to throw good money after bad and withhold the next bailout installment.

If this happens, Greece will end up leaving the Euro.

We would like to say that China is following the example of Ireland and that the economic situation is improving.  Unfortunately, the facts appear to imply otherwise.

Industrial production grew only 9.5% in June, the lowest since May 2009, and electricity production, seen as a more objective indicator of Chinese growth, managed only a 2.1% increase.  Exports grew a mere 1% in July with shipments to the EU down 16%.

Europe isn’t the only reason China’s exports are slowing.  Higher wages are eroding China’s competitive advantage with salaries for urban households increasing 13% in the first half of the year.

The Boston Consulting Group, in fact, estimates salaries in China could top those of Mexico this year if differences in productivity are included.  We still have faith that China will pull out all the stops in order to avoid a hard landing during the upcoming political transition, but they are clearly facing some stiff head winds.

So China is doing everything they can to prevent economic growth from stalling and the ECB has proclaimed they will do “whatever it takes” to save the Euro.

What about the U.S. Federal Reserve?

Has economic data been bad enough to force the Fed to embark on another program of quantitative easing?  Perhaps more importantly, does quantitative easing even work?  It sure helps get stock prices moving, but does it strengthen the economy or put more Americans back to work?

So far global investors have been giving the U.S. dollar and debt market a free pass by viewing the U.S. as a safe haven from the problems plaguing Europe and China.  However, it was only last year that the U.S. lost its coveted AAA debt rating and many feared investors would start demanding higher U.S. interest rates.

In fact, the opposite has happened and interest rates have moved considerably lower.  As Europe can attest, however, investors can be very fickle and some fear more quantitative easing could result in higher inflation, especially with higher food prices threatening to become a problem next year.

The September Federal Reserve meeting will probably be their last chance to act before the election so we should have the answer next month.  Our bet: look for the Fed to step in and buy mortgages.

It will be a game time decision, but unless August employment data is better than expected and retail spending picks up, the Fed will feel compelled to do something, and helping out homeowners and bank managers is always a safe bet.  Of course if the market continues to rally, they might be tempted to sit on the sidelines.

Overall, the markets need to see the ECB come through with a detailed plan to help reduce Spanish and Italian bond yields or it’s going to be a rocky end to the summer.

It would be nice to see the Fed come through with additional quantitative easing, but some kind of bond buying (quantitative easing) in Europe would be a much bigger catalyst for the market.

The U.S. Economy


Second quarter GDP grew a mere 1.5% in the U.S., compared to 2% in Q1 and 4.1% for Q4 2011.  Slowing consumer growth was the main culprit, though business spending has also shown signs of slowing.

Leading indicators were negative in July, but manufacturing improved (though modestly).  Some regional manufacturing indicators were pointing towards an expanding manufacturing sector; nationally, however, the ISM index was still in contraction territory.

Manufacturing was a positive driver for the U.S. economy earlier in the year, but a slowing global economy has taken a toll on the manufacturing sector.  A revival in the U.S. housing market and a stronger U.S. consumer are now seen as the best bets for driving U.S. economic growth higher.  Or not.

Only last June the Federal Reserve was forecasting GDP would grow between 3.3% and 3.7% in 2012, but now are predicting GDP will struggle to increase 2.4% and growth could be as low as 1.9%.  Of course, if no agreement is reached before year-end and the U.S. falls off the “fiscal cliff” (a series of tax increases and spending cuts), a recession is almost a certainty.

A recent WSJ poll of 47 economists put the odds of this happening at only 20%.  70% believe a deal will be reached on a temporary extension, kicking the problem down the road a few months.  Just the threat and uncertainty, however, is estimated to take 0.6% off GDP growth in the second half of the year.

The job market got some much needed relief in July, as 163,000 new jobs were created, with 172,000 coming through the private sector, but losing 9,000 government jobs.  After a string of poor reports (June was revised down to a 64,000 increase and May saw only 87,000 new jobs created), July came through with the largest gain since February.

It wasn’t all good news, however.  Wage growth ticked slightly lower (which is tough to do given how low it was already) and the unemployment rate increased a tenth of a percent to 8.3%.

There is some concern that seasonal adjustments played a role in the higher jobs tally given expected summer shutdowns in the auto industry have been cut back this year, resulting in the government overestimating the number of new jobs created in this sector.

Regardless, the markets reacted positively, which is all that matters, until next month.

Headline inflation remains well under control with energy prices continuing to have a positive impact.  Core inflation, however, remains stubbornly above 2%.  With crude oil prices drifting higher in July, headline inflation could come under some pressures in the coming months.

Perhaps an even bigger threat for higher inflation than oil prices, however, is higher food prices.    The United Nations Food and Agriculture Organization recently reported its index of global food prices increased 6% in July, the largest increase since November 2009.

Corn and soybean prices (up 47% and 26% respectively since the end of May) are moving higher due to the worst drought to hit the U.S. Midwest in 50 years, while unseasonably warm temperatures in Russia are impacting the wheat harvest.  In Brazil, heavy rains have damaged the prospect for this year’s sugar crop.

The U.S. Department of Agriculture expects food prices to increase 3% to 4% next year as higher prices move their way through the supply chain.  Fortunately, it is estimated only 14% of U.S. consumer spending is allocated to food.

This is not, however, the case in the developing world, which will be harder hit by higher food prices.

Both consumer confidence indices were higher in July, but the increases were marginal and they were off depressed levels.

Retail sales fell for the third month in a row in June, the first time this has happened since 2008.  Lower gasoline prices accounted for some of the decline, but a higher savings rate indicates a general apprehension by U.S. consumers to spend.

One bright light, however, is July same store sales, which came in stronger than expected.  July is a transitional month for retailers as they clear our inventory and make room for the all-important back to school season.

If momentum from July carries forward to August, the prospects for Q3 GDP growth would brighten considerably.  Also, one can’t discount the impact of Apple’s annual Fall iPhone release.

The recovery in the housing market remained on track last month.  Existing home sales in June moved lower versus May, but prices were higher.  Even more important, inventories remain at healthy levels and new home construction is rebounding nicely.

One of the reasons inventories have fallen is owners are reluctant to sell, sensing prices are on their way back up.  Also helping keep inventories in check are fewer bank foreclosures, which according to Zelman & Co. are down 23% versus last year to their lowest level since 2009.

More banks are opting go the “short sale” route (homeowners sell for prices below the value of their mortgages, but banks agree to call it even), where price discounts tend to average only 15% versus up to 40% for foreclosures.

The so called “shadow inventory” is still a problem, however.  It is estimated more than 3 million homes are in some stage of foreclosure or close to it.

Even worse, while CoreLogic estimates recent price appreciation has resulted in approximately 700,000 homeowners moving into a positive equity position, more than 11 million, or 24% of all homeowners, still owe more than their homes are presently worth.

We are happy to see the housing market showing signs of recovery, but that is still one big headwind for the U.S. economy.

The U.S. trade deficit narrowed in May, largely due to lower oil prices. Higher exports are a positive, though it is unlikely to be sustained given slower global growth, particularly in Europe.

Of particular concern to politicians critical of China’s trade policies, the U.S. trade deficit with China continued to move higher.  It increased nearly 6% in May and is up 17% in the first six months of 2012 to nearly $100-billion.

To make matters worse, the yuan has actually fallen just over 1% versus the dollar, adding fuel to calls that China is a currency manipulator.  This might, however, have more to do with U.S. dollar strength than Chinese yuan weakness, as the yuan is up nearly 6% on number two trading partner, Europe, and is up 1.3% versus a global basket of currencies.

Facts, however, matter little during a U.S. election year.

A better job market and continued progress in the housing market gives us some comfort that the U.S. economy might not be as weak as feared.  Perhaps the warmer than normal winter just borrowed some growth from spring, resulting in a few soft months?  Even if this turns out to be the case, there are still a lot of headwinds and growth is expected to be modest, at best.

The Canadian Economy

GDP growth came in a little light in May, increasing only 0.1% and putting Q2 on track for a sub 2% growth rate.  Mining and oil & gas extraction were strong, as were retail sales, but manufacturing and construction were weak.  Leading indicators were negative, though purchasing manager indices were still indicative of a growing manufacturing sector.

The Bank of Canada remained on the sidelines for a record 15th meeting in a row in July, lowering their forecast for GDP growth to 2.1% this year and 2.3% in 2013 versus an estimate in April of 2.4% for both years.

Despite signs of slowing growth, however, Governor Carney maintained his previous stance that the next likely move in interest rates by the bank would be to raise interest rates rather than lower them.

It was a disappointing month for the Canadian job market, as just over 30,000 jobs were lost.

While this was much worse than expected, we can take some comfort from the fact 21,300 full time jobs were created and all the losses (and then some) came from part time positions.  Hourly wage growth was also higher at nearly 4%.

No, July was not a banner month, but Canada has added a net 139,000 jobs since last year and full time positions are up 1.4%.

Inflation continued to moderate in June, mainly due to lower energy prices.  With core inflation below 2%, the Bank of Canada has room to cut rates if they so choose.  So far, however, they show no signs of doing so.

Consumer confidence remains strong and retail sales were acceptable in May.  Scotiabank has been telling Canadians “you’re richer than you think,” and people may be starting to believe them.

Environics Analytics WealthScapes recently pointed out that the average household net worth in Canada exceeded that of the U.S. in 2011 $363,202 to $319,970.  Of course the decline of house prices in the U.S. and the rise in Canada is the major reason.

Canadians, in fact, have almost four times more real estate equity than their southern cousins, while Americans hold greater non-real estate liquid assets.  When people feel richer, they tend to spend more, which is what is happening in Canada.

Too bad it might not last.

The housing market is beginning to show signs of cooling, especially in Vancouver and Toronto.  Existing home sales were lower in June and prices were off nearly 1% versus last year.

Most of the decline was due to Vancouver, as seven out of ten markets actually saw prices increase.  Excluding Vancouver, prices were actually up 3.2%.  Residential sales in Vancouver fell over 11% in June and July saw the lowest number of sales during any month in the last 10 years.

Even worse, 18,000 properties remain listed for sale, nearly 20% higher than last year.  Given these stats, prices are actually holding up pretty well, for now.

Cracks are also forming in the Toronto condo market with a record 18,123 condos up for sale at the end of June.  Unfortunately for the sellers, a record 343 new condo buildings are presently under construction in the Centre of the Universe.

We don’t necessarily see a crash in the housing market, but a correction is long overdue.

Canada’s balance of trade was in a negative position for the second month in a row in May as export growth stagnated.  Increases in machinery and equipment exports were more than offset by declines in almost everything else, particularly energy.

Given current trends, exports are likely to have a negative impact on GDP growth.

Not as good month for the Canadian economy last month.  We have some concerns with a potential correction in the housing market and the resulting impact to the overall economy.

We also worry that higher oil prices could drive the Canadian dollar higher, hurting the manufacturing sector.  The job market is relatively healthy, however, and improved fortunes south of the border will help sustain economic growth in Canada.

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

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