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Bonds Breaking Bad in 2013?

Monthly Market Commentary | December 2012

Highlights This Month

Read this month’s commentary in PDF format

The NWM Portfolio

It was a risk on month in December.

Bonds were unchanged with the NWM Bond Fund flat.  Short rates backed up with two-year Canada’s going from 1.06% at the end of November to 1.14% at the end of December.  Ten year Canada’s followed suit with yields increasing from 1.70% to 1.78%.  For the year, the NWM Bond Fund returned 2.0%.

High yield bonds were higher in December, with the NWM High Yield Bond Fund gaining 1.1%.  2012 was a good year for high yield bonds with the NWM HYB Fund up 10.4%.

Mortgages continued to provide steady returns in December, with the NWM Primary Mortgage Fund gaining 0.2% and NWM Balanced Mortgage Fund increasing 0.4%.  This is a little lower than last month.

Going forward yields are unchanged from last month for the Primary Fund at 4.2%, but down 0.3% to 6.7% for the Balanced Fund.  For the year, the NWM Primary Mortgage Fund returned 3.9% while the NWM Balanced Mortgage Fund delivered 6.8%.

Preferred shares were up in December with the NWM Preferred Share Fund gaining 0.9%.  We continue to selectively reposition the portfolio by trading out of issue-trading at large premiums we feel are at risk of being redeemed.  The new issue market has slowed considerably so we are active in the secondary market in order to deploy cash.

Canadian equities were stronger in December with the S&P/TSX gaining 1.9% (total return, including dividends), while the NWM Strategic Income Fund predictably lagged, returning 1.3%.  Given the call options and defensive cash weighting, we would expect to under-perform in a strong market.

Because we presently have a more constructive view of the market, we continue to run the fund a little more aggressively.  The cash weighting has moved a little higher, but this is a short-term issue.  We would look to get back to 5% cash in the near term.

We have also been less aggressive in writing call options, with just over 20% covered as of mid-January.  Because of this, the running yield of the portfolio is about 5.2%.  We would expect to write some more options in the near term and get the yield up to 5.25-5.50%, but we would also like to leave a little more room for capital appreciation than in previous months.

Foreign equities were on fire in December with all of our external funds posting positive returns during the month.  The NWM Global Equity Fund gained 3.3% while the MSCI All World Index was up 2.1%.  For the year NWM Global Equity Fund gained 17.1% versus 13.3% for the MSCI All World Index.

Real estate put in another strong performance in December with the NWM Real Estate Fund up 2.6%.  For the year, the NWM Real Estate Fund was up 15.7%.

Even in a strong month there has to be a laggard, and the alternative investment space continued to play that role in December.  Gold bullion was down 2.5% in Canadian dollar terms and gold stocks also declined resulting in a decline for the NWM Precious Metals Fund of 3.2%.

For the year, gold bullion in Canadian dollar terms was up 4.0%, but the NWM Precious Metals Fund was down 6.9%.  This is actually a pretty good result.  Sprott Hedge II was down 30.9%.

The NWM Alternative Strategy Fund was up 0.9% in December, but was down 2.8% for the year.  2012 was a bad year to be a CTA.  We expect better days in 2013.

December In Review

By Rob Edel, CFA

A strong rally on the last day of the year left markets firmly in the black for December with the S&P/TSX gaining 1.9%, while the S&P 500 and Dow advanced 0.9% and 0.8% respectively.

Results for the fourth quarter were less encouraging as the S&P/TSX managed a 1.7% gain, but S&P 500 declined 0.4% and the Dow fell 1.7%.

For the year, it was the U.S. exchanges leading the way, with the S&P 500 up over 16% and the Dow ending the year 10.2% higher.  The S&P/TSX returned a more modest, but still respectable, 7.2%.

MMC-2012-12-Composite index

Bonds – especially high yield bonds – also did well in 2012.  The riskier the credit, the higher the return in 2012, with CCC rated junk bonds topping the charts at around 18.3% return compared to Treasuries at about 1.8%.

“Frontier” emerging market debt (think Africa) returned 21.5%, despite a potential default by Belize.  To show just how frothy the bond market has become, consider that Mexico issued a 100-year bond in 2010 with a 6.1% coupon.

The yield of this issue traded down to a mere 4.5% in 2012.  Not a very high return for the next 98 years considering that in the previous 100 years Mexico went bust three times.

MMC-2012-12-The Chase

Companies have taken advantage of bargain basement borrowing rates and issued a record $353-billion in debt during 2012 versus the previous record set in 2010 of $286-billion.

New issues were also longer and contained fewer protections for investors. With the Fed buying so much low risk product, investors have been left to pile into the higher-risk issues.  For 2013, RBS estimates about $1.328-trillion in new (after subtracting maturing debt) government and investment grade debt will be issued.

If the Fed continues with its $85-billion per month buying program ($40-billion in mortgages and $45-billion in long-term Treasuries) for the entire year, it will leave just over $300-billion for investors to fight over.

MMC-2012-12-Sales of junk-rated

So far, investors are unphased and can’t seem to get enough fixed income exposure, even when potential future returns look poor at best. 

U.S. investors poured $131-billion into investment grade bond funds in 2012 and $30.1-billion into high yield bond funds.  Globally, over the past three years, investors have allocated $700-billion to bonds.

And stocks?  Despite strong returns in 2012, U.S. investors pulled $24-billion out of U.S. stock funds, and globally, over the past three years, investors have sold almost $300-billion.

With the current price/earnings ratio of the S&P 500 at 14 and below the 10 year average, valuations look reasonable.  Taking the reciprocal of the 14 times P/E multiple produces a 7% earnings yield, which compares very favorably to Treasury yields of less than 2%.

Even stock dividends (currently averaging just less than 2.5%) are higher than Treasuries for the first time in decades.

MMC-2012-12-Hot Pursuit

Bonds have been an incredible investment over the past 30 years, and as Barclay’s Michael Gavin recently pointed out, investors who stayed invested in 10-year U.S. government bonds over this time period would have returned over 5% more than inflation.

Most traders and portfolio managers have never experienced a sustained bear market in bonds.  This might be about to change. It may be time to look at what hasn’t worked over the last few years, rather than what has worked.  Equities, for example, have not worked, and could very well be on the rebound.

To quote The Great One (Wayne Gretzky, not Warren Buffet): “A good hockey player plays where the puck is. A great hockey player plays where the puck is going to be.”

At some point, the U.S. Federal Reserve will start reversing the extremely accommodative monetary policy that has been in place since the start of the financial crisis.  And maybe that time is now.

In December, bond yields started moving higher and continued to rise in early January, with bond prices losing ground over 3% in just the first few trading says of the year, effectively wiping out a year’s worth of coupon interest.

While optimism for a favorable conclusion to The Fiscal Cliff and a last minute deal were the main reasons for the increase in yields, we believe earlier actions by the Federal Reserve helped set the tone.

The Fed has stated it is their intention to keep short-term interest rates at close to zero percent until at least the end of 2015.  But in December, for the first time, The Fed included an employment rate target in their monetary policy.

The Fed now plans to keep rates as is until the unemployment rate falls to 6.5%, as long as inflation stays below 2.5%.  While this makes the Federal Reserve’s future actions much more transparent, it also means rates could be going up much sooner than previously planned if the economy recovery continues to gain traction.

In addition, minutes of the Federal Reserve’s last policy meeting revealed a split in opinions regarding the Fed’s asset buying program.  While some wanted to continue the buying until the end of the year as expected, some wanted to end the program much earlier.

There was even an undisclosed number who felt the program should end right now.  They question the effectiveness of continued purchases and fear the Federal Reserve’s growing balance sheet will make it harder to tighten credit if inflation heats up.

Economists share their concern.  A recent WSJ poll of 49 economists found 52% believed the bond buying should stop, citing concerns that more buying will distort the market and make Treasuries too expensive.  Too late for that.

With the U.S. economy looking stronger and the Federal Reserve showing some incremental signs of tightening monetary policy, traders won’t need much prodding to send rates higher.

MMC-2012-12-Creeping Higher

Of course traders have more than just the Federal Reserve on their radar screens.  Developments in Washington and the battle over The Fiscal Cliff overshadowed anything the Fed was up to in December.

With tax increases and spending cuts threatening to greet investors as they rang in the New Year, a partial deal was hammered out preventing tax rates from rising on everyone except those making more than $400,000 per year (and couples earning over $450,000).

The “unfortunate rich” will see their marginal tax rate increase to 39.6% from 35%, the first major tax increase in 20 years.  Also, all income earners will see an increase in Social Security tax as it returns to the original 6.2% level (deduction from payroll) versus 4.2% previously.

But the party didn’t end at midnight December 31.  The looming $110-billion across-the-board cut in spending (also referred to as “sequester”), was kicked down the road a couple of months and the debt ceiling has been hit and needs to be raised by March (or so) or the U.S. will effectively default on its national debt.

MMC-2012-12-Bigger Bite

We think the chances of the U.S. defaulting are very slim.  The debt ceiling will be raised.  There is going to some heavy politicking, but Congress won’t stand by and let this happen.  It’s in neither the Republicans nor the Democrats best interests.

The spending cuts are a different issue.  While it was generally believed the Democrats held the stronger hand in regards to higher tax rates for the rich, there is a strong case to be made that the moral high ground is now held by the Republicans and their demands for cuts in entitlement spending.

Democrats might be disappointed if they believe Republicans will be forced into cutting a deal because they won’t stand by and let defense spending be cut.  If no deal is reached, the spending “sequester” kicks in and U.S. debt will be cut by $1.2-trillion over the next 10 years.

Not quite the grand bargain the Republicans are looking for, but a move in the right direction as far as the GOP is concerned.   The Republican Party is strongly for fiscal restraint, while the Democrats appear to want to protect social programs.

Perhaps the recent Economist magazine cover with republican House leader John Boehner dressed as a fiscally prudent German and President Obama attired as a socially conscious Frenchman best depicts the current environment in Washington.

MMC-2012-12-The Economist.png

Republicans might be okay to let the spending cuts take effect if they don’t get meaningful entitlement program reforms so it could be the Democrats turn to blink.

Unfortunately, the market hates uncertainty.  The Fiscal Cliff debate had a negative impact on consumer confidence and continued uncertainty could further slow economic growth.

On the bright side, we continue to see positive signs in the U.S. economy, especially with the U.S. housing market.  We are also starting to see signs of stronger economic growth in Asia with purchasing manager indices of South Korea, Taiwan and India all moving higher.

More significantly, the Chinese manufacturing sector is expanding again, with the HSBC China PMI index increasing to 51.5 in December versus 50.5 in November.  Equity markets are starting to take notice.  After falling 10% the first 11 months of the year, the Shanghai Composite rallied 14.6% in December.

MMC-2012-12-Revving Up

 

Even Europe was relatively quiet during December.  ECB President Mario Draghi’s Outright Monetary Transaction program and the threat of unlimited central bank intervention continue to help drive Italian and Spanish bond yields lower.

MMC-2012-12-Steady Climb

Euro-zone consumer and business confidence also moved higher in December versus the previous month, and retail sales rose for the first time since July.

Europe is not out of the woods yet, however.  Unemployment continues to move higher with the Euro-zone jobless rate hitting 11.8% in November versus 11.7% in October.  For workers 24 years of age and under, the news is much worse with the unemployment rate hitting 24.4%, their highest levels since records began in 1995.

Given unemployment rates are still rising, most forecasters believe the fourth quarter will see the Euro-zone report a decline in GDP for the third consecutive quarter.

MMC-2012-12-A year in the Euro zone

Going forward, keys to watch for Europe, include elections in Italy and Germany.

Italians go to the polls on February 24-25, and while financial markets would like to see Mario Monti stick around and continue his policy of austerity and economic reforms, Italians are growing weary of recession and could opt for a leader like former Premier Silvio Berlusconi, who provides great theatre, but might not be the best cure for Italy’s long term economic ills.

Germans head to the polls in September or October, and while Chancellor Merkel’s popularity remains high, her coalition partners are fading.  It is unlikely Merkel will be making any bold moves before the election, and if German public opinion turns against future Euro-zone bailouts, the future of the Euro could again be in question.

Germany is the key.  If the German people don’t buy into the program, the Euro is done.

Nobody knows this better than Greece.  With a new debt plan under their belts, business and consumer confidence recently soared to a three-year high and is now close to the Euro-zone average.

Perhaps they are a little too optimistic.  Greece’s debt situation is still unsustainable and GDP is expected to decline another 4.5% in 2013.  Out of a total population of 11 million, only 3.6 million Greeks have jobs.

The Greek people are suffering.  In the past two years, over 700 Greek families have asked the SOS Children’s Village, an international charity, to take in a child due to economic reasons.

Malaria, mostly eradicated in Greece in 1974, has made a comeback, a clear sign of a health care system in turmoil.  Many question whether the current coalition government will survive and fear a more radical political party could come to power.

MMC-2012-12-Hardest Hit

MMC-2012-12-Deep Freeze for Greek Economy

One last stop on our European tour of worry: France.  Highlighted in the Economist magazine as the time-bomb at the heart of Europe, many fear France could be the next country to suffer a financial crisis.

Moody’s recently followed Standard & Poor in stripping France of its AAA credit rating, citing persistent structural budget deficits.  France, the world’s fifth largest economy and sixth largest exporter, has more large multinationals in the global Fortune 500 than Britain.

Unfortunately, however, France has been losing competiveness to Germany for years and has fewer small- and medium-sized companies (which are typically responsible for creating most new jobs) than Germany, Italy, or Britain.

France has a large and growing current account deficit and a debt to GDP ratio of 90% and rising.  Like Spain, Italy, and Greece, France needs to reform, but is recently elected Socialist President Francois Hollande up to job?

While acknowledging reforms are needed, Hollande has responded with a series of tax increases and a partial roll back of the previous administration’s increase in pension age.  Perhaps Canada should have traded Bank of Canada Governor Mark Carney to France instead of Britain.

If the Bond market starts attacking French government bonds, all bets are off.  For all our sakes: vive la France.

How will 2013 play out? Overall, the current dust up between Republicans and Democrats in the U.S. could result in slower economic growth in the first half of 2013, but a stronger housing market and recovering employment market should lead the way.  Strength in Asia will help.  The weak link remains Europe.

Can real reforms start to stimulate economic growth before austerity weary Greeks and Spaniards revolt?  Is there the political will in France to do the right thing? And most importantly, will Germany agree to keep paying the bills?

Answers to these questions will go a long way to determining how markets fare in 2013.

MMC-2012-12-France's competitiveness

The U.S. Economy

MMC-2012-12-Economic Growth-Table-US

Third quarter GDP growth was revised even higher in December as health care spending and export growth contributed more than previously estimated.  Most economists estimate growth will decelerate to 1.3% in the fourth quarter and 1.7% in the first quarter of 2013.

Manufacturing indices point to a modest increase in December but higher inventories could detract from growth as excess inventories are worked off.

Consumer confidence has dipped, most likely due to the uncertainty over the fiscal cliff, and could result in slower retail sales.  A similar phenomenon happened during the debt ceiling debate last year.  Hopefully, strength in the housing market and a slowly recovering employment market should enable growth to resume in the second quarter.

MMC-2012-12-Budget Brawls

MMC-2012-12-Employment-Table-US

A decent, but not exceptional month for job growth in December.  The quality was good, with all the gains being in the private sector, and hours worked and wage inflation both moved modestly in the right direction.

The manufacturing and construction sectors added 25,000 and 30,000 jobs respectively while 13,000 government jobs were eliminated.  Manufacturing and housing are two areas that we would expect to see continue to add jobs in 2013. The U.S. lost approximately 2.2 million construction jobs during the housing bust and has only added about 58,000 since January 2011.

For the year, the private sector added 1.9 million jobs and on average, the U.S. added 152,900 jobs a month in total.  This is slightly below the 153,300 average last year, but the fourth year in a row of positive job growth.

MMC-2012-12-Bluer Skies

MMC-2012-12-Inflation-Table-US

Headline inflation fell in November due to lower energy prices, while reduced apparel and used car and truck prices impacted core inflation.

Inflation below 2% gives the Federal Reserve a green light to continue to pursue a simulative monetary policy, despite what some Fed officials might think.

MMC-2012-12-Consumer Confidence-Table-US

Both the University of Michigan consumer sentiment index and the Conference Board consumer confidence index fell in December, most likely due to uncertainty over the fiscal cliff.  This is, at best, a short-term negative for consumer spending and economic growth.

MMC-2012-12-The Consumer-Table-US

December same store sales were higher than expected but probably overestimate what is generally being described as a disappointing Christmas season.

The Thomson Reuters same store sales index for December came in at a decent 4.5% versus a 4.2% increase last year.  Excluding Costco, which delivered an exceptional 8%, the Thomson/Reuters’ number would have come in at 2.8%.

Again this year, shoppers waited until the last moment to finish their buying as a poll conducted by Consumer Reports indicated 68% of consumers still hadn’t finished their Christmas shopping by December 20th.

Some retailers appeared to sacrifice profits at the expense of sales in order to move inventory.  We will have to wait until next month to see the final retail sales numbers and the impact on profit margins, but it would appear December sales were neutral at best.

MMC-2012-12-Housing-Table-US

Existing home sales increased nearly 6% in November and topped the 5 million unit level (annualized) for only the third time since July 2007.  Prices were also firm and inventories hit a seven year low of 4.8 months.

While there is still some concern the shadow inventory (homes that have been foreclosed or are in the process of being foreclosed, but haven’t hit the market yet) could cause current prices to fall once more, even the shadow inventory is showing signs of shrinking.

Real Estate Consulting’s John Burns recently estimated the shadow inventory has fallen to 3.4 million units versus a peak of 4.7 million in 2009.  Zillow estimates foreclosures typically sold at 24% discounts three years ago, versus a mere 7.7% discount in September.

MMC-2012-12-Open House

People are back buying homes.  One of the reasons we are optimistic that this will continue, is household formation has started to increase again.

A lack of jobs for adults aged 18 to 34 resulted in a general migration back to mom and dad’s basement during the financial crisis.  Employment is back on the rise and we see this as a key driver of new housing demand.

According to Federal Reserve Bank of Cleveland economist Timothy Duane, there were 2 million more 18-34 year olds living with their parents at the end of last year compared to four years ago.

The Census Bureau, however, reports that at the end of March, the U.S. added more than 2 million households in the previous 12 months, triple the annual average of the previous four years.

Americans are also starting to move more frequently, usually because of a better job opportunity.  Almost 12 million people, or 3.9% of the U.S. population, moved to a different county in 2011, the highest level since the start of the recession.

A mobile workforce is considered a competitive advantage for an economy as it usually results in a better match between skills and jobs.

MMC-2012-12-Fresh Start

MMC-2012-12-Trade-Table-US

The trade deficit widened slightly in October, with exports contracting at a greater rate than imports due to a large increase in the petroleum deficit.  That both imports and exports declined is disturbing, as it is usually an indication of slower global economic growth.

The Canadian Economy

MMC-2012-12-Economic Growth-Table-CAD

GDP growth was modestly positive in October and manufacturing indices were solidly in expansion territory.

There are concerns a slowdown in the housing market could impact economic growth in Canada but this isn’t the case so far.  A stronger auto industry and recovering U.S. housing and employment market should help offset any weakness from a slower real estate market in Canada.

Also, hockey is back!

MMC-2012-12-Employment-Table-CAD

Another strong month for the job market with the unemployment rate moving down to 7.1%.

For the year, Canada created 312,000 new jobs, all full time.  The only areas of weakness remain the youth market, where the unemployment rate has been stuck around 14% for the past couple of years, and the self-employed market, which declined by 22,000 in 2012.

Self-employed workers surged during the recession, making one wonder whether Canadians turned to self-employment out of desperation rather than opportunity.

MMC-2012-12-Inflation-Table-CAD

Inflation remains a non-issue in Canada with headline inflation increasing at its slowest pace in three years.

MMC-2012-12-Consumer Confidence-Table-CAD

MMC-2012-12-The Consumer-Table-CAD

Apparently, Canadians were also watching The Fiscal Cliff debate in December, as consumer confidence declined.  Were Canadians concerned about the Mayan end of the world prophecy?  Perhaps losing Bank of Canada Governor Mark Carney to the Bank of England dampened our spirits?

Honestly, with the employment growth Canada has seen this year, I am not sure why consumer confidence was lower. A slower housing market is really the only credible contributing factor. Regardless, retail spending was in line with higher auto and auto parts spending helping drive growth.

A recent Harris/Decima poll indicates Canadians are starting to get more serious about reducing their debt with 17% selecting debt reduction as their main financial priority in 2013.

What we say and what we do can be quite different, however.  We said the same thing last year and household debt-to-income increased to a record high of 164.6%.

MMC-2012-12-Housing-Table-CAD

The Canadian housing market continues to correct.  The question is: will it be a hard or a soft landing?

Vancouver, which is probably at a greater risk of a hard landing than most Canadian cities, saw sales decline 27.6% in November, but the MLS home price index was off only 1.7%.

Without higher interest rates or unemployment, many would-be sellers don’t have to sell for financial reasons, unlike U.S. homeowners during the financial crisis.  If, however, a continued reduction in sales activity leads to a dramatic supply/demand imbalance, prices could start to fall more aggressively.

Either way, construction spending and loan growth looks to slow, and this could provide a headwind for economic growth in Canada in 2013.

MMC-2012-12-Trade-Table-CAD

The trade deficit narrowed in October due to a broad based decline in imports.  Europe is the main culprit.

The housing market could provide a headwind for economic growth in Canada over the next year, but strength in the U.S. economy should help offset much of the weakness of a soft landing.

  
What did you think of the way 2012 ended for the markets?  Tell us in the comments below!

Comments (1)

  • Peter Mortifee said on January 23, 2013 @ 1:42 pm

    Rob,

    Thanks for another reflective article. How long does it take you to write these extensive reviews every month? Do you have a shadow writer somewhere in the back ground – is this what Karen gets up to on weekends?

    An interesting question that you refer to in this article is the timing of the end to the 20 year bull market in bonds. How do we as investors manage our asset allocation (leaving mortgages and real estate to the side for the moment) to take advantage of this shift? Investment grade high yield bonds have been an important source of cash flow over the last several years – when do we begin the shift elsewhere and into what, while keeping the cash flow oriented approach in tact?

    Cheers,

    Peter.

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