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Monthly Market Commentary | August 2012

Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

It was “risk on” in August.

Bonds were modestly higher with the NWM Bond Fund ending up 0.2%.  As with last month, this must have been entirely due to coupon interest as yields backed up slightly during the month.

High yield bonds had another positive month in July with the NWM High Yield Bond Fund up 0.6%.  The NWM Global Bond Fund lost 1.2%, not unexpected given the Canadian dollar was strong, gaining nearly 1.7%.

Mortgages continued to provide steady returns in August, with the NWM Primary Mortgage Fund gaining 0.1% and NWM Balanced Mortgage Fund increasing 0.5%, same as last month.  Going forward yields are 4.4% for the Primary Mortgage and 6.9% for the Balanced.

Preferred shares were up in August, with the NWM Preferred Share Fund gaining 0.5%.  We currently have about 1% in cash and are reviewing strategies on how to position the portfolio in the short-to-medium term.  We expect to be less active traders, but might take a stronger view on term and issuer concentrations.

Canadian equities were higher in August with the S&P/TSX gaining 2.7% (total return, including dividends) while the NWM Strategic Income Fund (SIF) only managed a 1.0% return.  This underperformance is expected, given the covered call options and other defensive characteristics of the SIF.  The running yield in the SIF is approximately 7.0%.

Foreign equities were also higher with all our external funds posting positive returns during the month, despite the strong Canadian dollar.  The NWM Global Equity Fund gained 1.6% while the MSCI All World index was up 1.0%.  Templeton Global Smaller Companies and Edgepoint were the standouts during the month, up 3.9% and 3.2% respectively.

In hedge fund world, gold bullion was up 4.8% in U.S. dollars and 3.0% in Canadian dollar terms.  Gold stocks reflected this strength, with the NWM Precious Metals Fund gaining 12.2%.  The prospects for more quantitative easing in the U.S. and Europe helped move gold higher.

AUGUST IN REVIEW

By Rob Edel, CFA

The summer rally rolled right into August, with the S&P/TSX gaining 2.7% while the S&P 500 and Dow rose 2.3% and 1.0% respectively.

The equity markets have been on quite a roll the last few months.  The S&P500 is up a respectable 10% since early June and the NASDAQ has soared almost 20%, reaching levels not seen since October 2000.

Of course Apple has played a big part in this, given it is about 13% of the index and is up about 60% this year.

Compared to these two U.S. indexes, the S&P/TSX is a bit of a laggard, up just under 6% from lows hit in mid-May, and up a mediocre 2% year to date.  In early September, however, the S&P/TSX has tacked on a couple more percent and looks to be joining the party.

Hopefully we are in store for an Indian summer rally.

While equity markets might be soaring, investors have largely been left behind.

Mutual funds featuring large company stocks are lagging the S&P 500 by nearly 5% in 2012, while stock hedge funds are about 9% behind.  Most of the underperformance has occurred the last few months with portfolio managers defensively positioned and missing out on the recent rally.

And who could blame them?  Turmoil in Europe, a slowdown in Asia, and a looming fiscal cliff in the U.S. – there is a lot to worry about.  So what is pushing equity indices higher?

For the most part, economic numbers in the U.S. are mixed, but the housing market looks to have bottomed and could start to stimulate growth south of the border.

The fact that most fund managers have missed the current rally also helps, because most will buckle under the pressure of falling behind their benchmarks and their capitulation buying will drive up equities further, if it hasn’t already.

Finally, and most importantly, central bank intervention by the ECB, China, and hopefully the Federal Reserve, is putting the wind behind the backs of this current move higher in the capital markets.

In early September, ECB President Mario Draghi finally released the technical details of the bond buying program announced on August 2nd.

Dubbed “outright monetary transactions” by Draghi and quickly referred to as “OMT” by traders (because everything in the world of finance needs an acronym), the ECB announced they stand ready to buy an unlimited amount of short-term sovereign bonds on the secondary market.

Any purchases by the ECB would not become senior to other bond holders and, to appease the Germans, any liquidity created through the transactions would be sterilized, meaning offsetting liquidity would be withdrawn from another part of the system.

Of course, there is a catch.  In order for a country to be eligible, they must apply for relief from the EFSF or ESM programs (I warned you about acronyms, they stand for European Financial Stability Facility and European Stability Mechanism) and adhere to the conditions they impose.

So far, the markets are very pleased with the program and Italian and Spanish government bond yields have rallied nicely.  The market reaction has been so favorable, in fact, that Spain and Italy might not even need to seek relief.

Just the threat of unlimited central bank intervention has traders wary of shorting Spanish and Italian debt and has provided Europe with some much needed breathing room.

Don’t kid yourself though, the problem has not been solved.  The Euro-zone economy is contracting, with Q2 GDP shrinking an annualized 0.7% in Q2.  Yes, Germany may be still growing, but at barely half the rate it grew in Q1.  Greece, Spain, Italy, Cyprus, and Portugal are all in recession, and France is barely breaking even.

As of July, there were 18 million Europeans out of work; the highest total in the Euro-zone since data began being collected in 1995.  At 11.3%, the unemployment rate has soared from the 10.1% recorded only a year ago.

Rolling out the ECB’s new OMT program and stabilizing the bond market is the easy part.  Now comes the heavy lifting.

Europe needs banking, fiscal, and eventually political union, which to many is deemed to be a non-starter.

The periphery of Europe needs to become as efficient as Germany, and soon, because Germany is not going to continuously pump money into a monetary union where they have no control or say on fiscal policy.  The can has been kicked down the road, but we are uncertain as to how long the road is.

And speaking of roads, it looks like China is going to be building a lot more of them over the next few years.

In early September, China’s National Development and Reform Commission announced their intention to spend ¥1-trillion, or $157-billion US on 60 infrastructure projects that would include 13 highways, as well as 25 urban rail projects (aka subways), seven waterway projects and nine waste water treatment plants.

To put the magnitude of the program into perspective, the total cost of ¥1-trillion represents about 2% of China’s GDP, but is only a quarter the size of the massive stimulus package launched to counter the effects of the global financial crisis in 2008.

Chinese equity markets welcomed the spending plans by rallying almost 4%.

Everyone knows China’s economy is slowing, the only question is how much.

Official data, such as the official purchasing manager index, show manufacturing activity in China is contracting.  August exports were up only 2.7% versus last year and retail spending growth dropped to 13% in July versus more than 20% growth last year.  And these are the official numbers!

It is generally speculated China fudges the numbers a bit.  When looking at harder-to-manipulate indicators such as electricity consumption, economic activity looks to have slowed even more.

For further evidence, just look at the other Asian economies heavily dependent on demand from China, such as South Korea.  They are all headed lower.  Is the infrastructure spending plan enough?

Outgoing Chinese Premier Wen Jiabao recently conveyed his confidence in China’s ability to hit its 7.5% growth target this year, but he also let slip that China has accumulated a budget surplus of about ¥1-trillion this year and has another ¥100-billion or so in a special reserve fund that could be used as part of a massive fiscal spending program to help spur growth.

The ECB and Mario Draghi would kill for that kind of fire power.  Imagine the road they could build and how far they would be able to kick the can down it.

Will Ben Bernanke and the Federal Reserve follow the lead of the ECB and China and take measures to appease a worried market?

More specifically, will the Fed announce a much anticipated and hotly debated new quantitative easing program (QE3) whereby it would create money (out of thin air) and use it to increase its existing $2 trillion portfolio of U.S. treasuries and mortgages?

In late August, Fed Chairman Ben Bernanke laid the groundwork by defending previous QE programs and stating “we should not rule out the further use of such policies if economic conditions warrant.”

So have they?  It’s a close call.  Retail spending is decent and the housing market is appears to be turning.  Manufacturing, which looked so promising at the start of the year, has slowed, however, and employment growth has stalled.

There is a concern that the large pool of workers who have been without jobs for an extended period of time could become permanently locked out of the job market if new jobs aren’t created soon.

The explicit goal of central bank bond buying is to reduce interest rates in order to stimulate economic activity.  With interest rates so low already, even lower rates hardly seems a worthy goal.

In fact, a recent Wall Street Journal poll of 47 economists found that forecasters believed a hypothetical bond buying program of $500-billion would produce a mere 0.2% increase in GDP and reduce the unemployment rate by only 0.1%.

While the economists didn’t see much risk to inflation (only a 0.2% increase over the next year) many also believe the positive impact in the capital markets will be more muted this time.  Financial assets have already rallied in anticipation of the QE3 and subsequent QE programs have produced progressively shorter and weaker moves in the markets.

Investors are coming to realize you might get a short-term bounce, but it doesn’t solve any real problems, like balancing the budget, improving education, or creating well-paying jobs for the middle class.

Seems like just another form of kicking the can down the road to me.  And how long is the road?

One of the benefits of European turmoil for the U.S. is it has taken the market’s eye off just how bad the U.S. fiscal situation is.  

Unfortunately for the U.S., campaign rhetoric emanating from the upcoming Presidential election is threatening to bring it back into focus.  Already, Moody’s Investors Service has warned they could downgrade the U.S.’s current triple-A debt rating if no progress is made in stabilizing and eventually lowering the ratio of U.S. debt to GDP.

Of course Moody’s is a little late to the party, as S&P downgraded U.S. debt more than a year ago, but better late than never.  Everyone in Washington knows the U.S. has a debt problem.  Where their opinions differ is why, and how to fix it.

Republicans believe individuals only prosper when the overall country prospers, and only private enterprise is able to drive prosperity for the entire nation, not big government.  Accordingly, it is pointless to try and lift the fortunes of the middle class by taxing the rich and granting the middle class a larger slice of the pie if the overall pie isn’t growing.

For their part, the Democrats refer to this theory as “trickle-down” economics and believe it is socially unjust.  They believe government programs, funded largely by increased taxes for the rich, will help build the middle class.

Both have evidence to back their case.  Democrats point out that the marginal tax rate for upper income earners has declined over the years leaving them with a greater share of the nation’s wealth.

Republicans point out that while it is true the rich have become richer, they have also been paying an increasing share of total tax revenue collected, despite a declining marginal tax rate.  Is it fair that they bear an even greater share of the tax burden?

The ideological gap between the two parties has never been so wide.  Unless either the Republicans or the Democrats are able to win a decisive victory this November, it’s unlikely either party will be able to advance their platform and make meaningful reforms.

Even legislation that should get bipartisan support, like preventing the fiscal cliff, could get caught in the crossfire.  Normally gridlock is a good thing in Washington.  According to Moody’s, however, it might not be the case this time.

If you ask most people on Wall Street, they’ll tell you they think Romney should be elected, because not taxing the rich and stimulating business would have the most positive impact on the U.S. economy and stock market.  That said, they’ll also tell you they think Obama will likely be re-elected. 

Either way, a stronger American economy will only benefit Canada and the rest of the world.

The U.S. Economy

Second quarter GDP growth was revised up to 1.7% from 1.5% previously reported.  A slight positive, but still below trend for a normal economic recovery.

Leading indicators and industrial production were also modestly higher, though weaker manufacturing numbers bring into question the sustainability of this trend.

The good news for the U.S. economy is the housing market looks finally to have bottomed.  A recovery in building activity would give a boost to economic growth.  Offsetting this, however, is a slowing European and Asian economy that is hurting the manufacturing sector.

The result is most likely a continuation of the current anemic economic growth.  The services segment, meaning industries such as retail, casual dining, and health care, should fare better than sectors more leveraged to the global economy.

August was a disappointing month for job creation with less than 100,000 new jobs created.

The unemployment rate moved down to 8.1% from 8.3%, but only because 368,000 workers left the labor force.  Wage growth remains flat and the work week was basically unchanged.  Overall, there was not a lot of positives to take from the employment picture in August.

Not only are new jobs scarce, but the few that are being created are concentrated in lower paying job categories.

A recent report by the National Employment Law Project found lower wage occupations accounted for 21% of the jobs lost during the recession, but have contributed 58% of the new jobs created during the recovery.

Higher wage occupations more or less broke even, contributing 19% of the job losses and 20% of the gains in the recovery.  It’s middle income occupations that have taken the big hit, losing 60% of the jobs during the recession but only contributing 22% of the jobs created during the recovery.

The reason for the imbalance lies in the industries that have been hiring, namely food services, retail, and employment services.  Higher-paying industries like construction, manufacturing, finance, and real estate have mainly stayed on the sidelines.

This is why an improvement in the housing sector is potentially so important.  Not only would it help create jobs, but the jobs would be higher paying.

Inflation remains well under control, though there are some potential catalysts that could push prices higher in the coming months.  Food prices, of course, top the list.

With about 63% of the continental U.S. suffering from a drought and corn prices skyrocketing, expect food costs to move higher.  Fortunately, because the actual food component cost of a retail consumer food product is fairly low, increased grain prices like corn don’t actually influence overall prices that much.

For example, it is estimated the amount of wheat in a loaf of bread comprises only 3% of the retail price.  Accordingly, the Department of Agriculture increased their forecast for food price inflation, but only to 3-4% next year versus 2.5 to 3.5% this year.

Still higher than CPI, but not as much as feared, given the dramatic increase in corn and other grains.  Perhaps a bigger threat to inflation at the supermarket (and elsewhere) is energy prices, and unfortunately they also look to be heading higher.  Gasoline futures are up 19% over the past two months as inventories have tightened.

Finally, a stronger housing market is good for the economy, but not necessarily for the inflation rate.  Shelter costs comprise 31.5% of the CPI index and a change in the fortunes of the housing market could see the inflation rates move higher.

Don’t get us wrong, we don’t see a dramatic move higher in inflation in the short term, especially with wage growth virtually non-existent.  It is something we are watching, however, as higher inflation and the resulting increase in interest rates would have huge implications for investment returns.

A mixed result in August with the Conference Board reporting a large decline in consumer confidence while the University of Michigan indicated consumer confidence improved slightly.  Let’s split the difference and call it even.

It was a good summer for the malls as consumers were out in droves (ok, this might be a slight exaggeration).  As predicted last month, retail sales in July broke a three-month drought and increased a strong 0.8%.

Prospects for August remain bright with same store sales increasing around 6%.  Certainly the warm weather played a role, with sales of air conditioners skyrocketing, but the strength was generally widespread.

Retailers were earlier than normal with back to school promotions and consumers were receptive to their overtures.  According to the National Retail Federation, the average U.S. consumer with school age children is expected to spend an average of $688 on back to school supplies and clothes compared to $603 last year.

Perhaps the single most optimistic thing we see in the U.S. (and global for that matter) economy right now is the U.S. housing market and the potential that it has bottomed and is poised to start having a positive impact on economic growth for the first time since the housing bust.

Prices were stronger in June, with the S&P/Case Shiller index reporting a year-over-year increase for the first time in nearly two years.  Even more importantly, new home sales were up nearly 26% over last year and housing starts were up almost 22%.  New home construction has a long way to go before it reaches normal levels, but the trend is very positive and could have positive implications for the U.S. economy.  J.P. Morgan estimates each 250,000 in housing starts is equivalent to 1 million jobs in the U.S..

The U.S. trade deficit continued to narrow in June as higher exports and lower oil imports helped tip the balance of trade scales ever so slightly in the U.S.’s favor.  The gains might be short lived, however, as the economic slowdown in Asia dampens export growth and higher oil prices increase the cost of imports.

The U.S. is not creating enough jobs, and this is a concern.  The manufacturing sector is being dragged down by the slowing global economy, but the domestic economy could get a boost from a rebounding housing market.  The result is a continuation of the slow growth economic environment we have come to know and suffer through.

The Canadian Economy

GDP growth continues to grow at a modest pace in Canada.  Leading indicators were positive in July and the future prospects for manufacturing remains good with purchasing manager indices above 50.

The recent increase in the Canadian dollar might pressure the manufacturing sector; though the increase has been gradual, allowing manufacturer’s time to adjust.  The Bank of Canada reiterated that they are still more disposed to raise interest rates than lower them.

Our guess is the Bank of Canada is happy leaving interest rates where they are for the immediate future.

A huge rebound for the Canadian job market in August as 34,300 jobs were created, more than offsetting losses in July.  More than all the gains were part-time jobs, however, as 12,500 full-time jobs were lost, the first decline since January.

Interestingly, the increase in part-time jobs nearly offsets the 52,000 part-time jobs lost in July.  Also, almost all the job losses in July came from Quebec, as did almost all the gains in August.

Perhaps it is better to look at July and August together and conclude Canada created about 2,000 jobs a month, which is below par.  The unemployment rate was unchanged due to an increase in workers entering the work force.  Wage growth remains strong and higher than inflation.

While job creation in the U.S. has been dominated by lower paying jobs, this is not the case north of the border.  Employment in Canada has increased 2.6% over the past four years (ending in June) versus a decline of 3% in the U.S.

More importantly, a recent article by Linda Nazareth points out that jobs in higher-paying industries have increased 4.5% since mid-2008.  The energy sector has played a big role in this, increasing 8.6%, but other sectors such as construction, finance, insurance, and public administration have also contributed.

Like the U.S., however, middle-income jobs have been hit, falling 3.3% due to a nearly 12% decline in manufacturing.

Inflation looks to be well contained in Canada.  Food inflation may increase over the coming months, but it comprises only 14% of the CPI basket and any increase is likely to be a one-time event.

Retail sales were weak in June, falling 0.4%, though still up 1.7% over last year.  Slower consumer spending is probably a good thing.  Canadian consumers need to reduce their household debt and start to delever.  This will, however, provide a head wind for the economy.

If Canadians are going to start to delever, one of the first places they should start is with the housing market. 

Mortgage debt is by far the largest component of household debt and Canadians have been on a buying frenzy.  New mortgage rules and a more debt-wary consumer should slow demand in the future and lead to a modest correction in over-heated markets such as Vancouver and Toronto.

In fact, sales in Vancouver were down 21.4% in August according to the Real Estate Board of Greater Vancouver; however MLSLink Housing Price Index reported a mere 0.5% decline in prices.

Canada’s balance of trade continued to deteriorate in June as imports growth more than offset modest export growth.  Lower energy prices hurt export growth while higher auto sales helped.

Strong import growth is a positive indicator of the strength of the Canadian economy as a whole. However, unless the global economy (especially the U.S.) picks up, we don’t see this strength persisting.

A better month for the Canadian economy with strong job growth.  So far, the numbers look fine and Canada continues to be experiencing a modest, but stable economic recovery.

Stronger growth south of the border would help, as would a stable Europe and increased visibility in China.  A stronger Canadian dollar is a concern, however, and could negatively impact the manufacturing sector.

We also worry that a correction in the housing market could hurt consumer spending, but so far prices appear to be holding.
What did you think of August’s market activity?  Let us know in the comments below!

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