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Markets Sail, But Investors Miss The Boat

November 19, 2012

Highlights This Month

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The NWM Portfolio

It was a mixed month in October.

Bonds had another solid month with the NWM Bond Fund up 0.2%.  Rates, however, were effectively unchanged with two-year Canada’s going from 1.06% at the beginning of October to 1.07% at month’s end.  Ten year Canada’s actually backed up even more, with yields rising from 1.73% to 1.78%.  A (very) modest coupon accounted for all the return in short term bonds in October.

High yield bonds have a higher coupon and thus provided a little more return in October with the NWM High Yield Bond Fund gaining 0.9%.  The decline in Canadian dollar and higher coupon rates also provided a good environment for the NWM Global Bond Fund, which gained 2.2%.  The Global Bond Fund has provided very solid returns this year.

Mortgages continued to provide steady returns in October, with the NWM Primary Mortgage Fund gaining 0.3% and NWM Balanced Mortgage Fund increasing 0.6%.  Going forward, yields are 4.2% for the Primary Mortgage and 7.0% for the Balanced.

Preferred shares were up in October, with the NWM Preferred Share Fund gaining 0.4%.  We currently have less than 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 October with the S&P/TSX gaining 1.1% (total return, including dividends) while the Strategic Income Fund only managed a 0.8% return.  This underperformance is expected given the covered call options and other defensive characteristics of the SIF.

Given our generally favourable view on the U.S. economy, we have lowered the cash weighting in the SIF to around 6.5%.  We have also been less aggressive in writing call options (about a third of the equity positions covered) as volatility is fairly low, driving premiums lower.

We also are trying to leave a little more room for capital gains in the portfolio given the favourable QE III tailwinds being experienced at the moment and our positive view on the recovering North American economy.  As a result, the running yield in the SIF is approximately 6.0%.  We recently added forest product companies to the portfolio and established a position in a major trucking company.

In general, we think the REITs are fully valued.  In October we reduced our exposure and holdings to REITs in the SIF to four core names. Foreign equities were also higher with a majority of our external funds posting positive returns during the month.  The NWM Global Equity Fund gained 1.2% while the MSCI All World index was up 0.9%.

In Hedge fund world, gold bullion continued to march higher in October, increasing 2.9% in U.S. dollars.  In Canadian dollar terms, bullion was up only 1.4%.  Gold stocks reflected some of this strength, with the NWM Precious Metals Fund gaining 1.0%.

With unlimited quantitative easing, gold looks to be moving even higher.  A “grand bargain” solution for entitlement spending would be negative for gold.

OCTOBER IN REVIEW

By Rob Edel, CFA

It was trick and treat for the markets in October as the S&P/TSX gained 1.1% while the S&P 500 and Dow lost 1.8% and 2.4% respectively.

Year to date, though, it’s all treat with S&P/TSX up 5.4% while the S&P 500 and Dow are up a remarkable 16.4% and 12.2%.

Too bad most investors didn’t stick around to benefit. 

Despite doubling from their lows in March 2009, the Investment Company Institute estimates investors have pulled $138-billion out of stock mutual funds and exchange traded funds, while plowing $1-trillion into bond funds.

The result has been to drive yields in investment grade and high yield bonds to dangerously low levels.  The Barclays U.S. high yield index recently traded down just over 6% versus its 10-year average of just over 9%.

Companies have started to take advantage of the low rates with Dealogic reporting a record $1.2-trillion of new issues coming to market already this year with weaker companies particularly aggressive in raising money.

But even the best credits are finding current conditions too good to pass up.  Microsoft recently raised $2.25 billion of 5-year money at a paltry 0.27 spread over U.S. treasuries, which according to Dealogic, is the skinniest premium for such bonds since 1994.

The quest for yield has become even more absurd in the secondary market, where bonds of Exxon Mobil and Johnson & Johnson have traded at yields below that of comparable Treasuries.

Think about that for a second: why would an investor accept a lower yield on any corporate bond versus a U.S. government bond of the same term?  The U.S. is never going to default.  They may print an ever increasing amount of money and pay you back with worthless dollars, but they will pay you back.

While one could argue JNJ and Exxon might be in a better fiscal shape than the U.S. government and some investors may refer to them as “money machines,” they can’t really print money.  If the U.S government has to debase the U.S. dollar, JNJ and Exxon will be paying you back with the same worthless dollars.

So take your choice, JNJ bonds yielding 0.21% and maturing in about 18 months, or the equivalent U.S. Treasury yielding about 0.26%.

Of course there is a third choice, you can buy JNJ common stock and collect the 3.5% dividend.  We think this is a better bet.

It’s not that stocks can’t go down; it’s just that the risk-return trade off favors stocks over bonds at this point.  Also, as we will discuss below, we see some positive signs brewing in the domestic U.S. economy and think this will be good for the equity markets longer term.

Short term, we share some of the markets’ trepidation in October as third quarter earnings continue to come in lower than expected.  With 70% of companies having reported, Factset recently estimated S&P 500 earnings shrank 0.5%, which, if it holds, will mark the end of an 11-quarter streak of positive earnings growth.

Revenue growth was even lower at -3% as companies continue to slash costs in order to preserve margins.  Next quarter doesn’t look any better with 76% of companies issuing Q4 guidance lowering expectations.

Another reason for the U.S. market’s skittishness in October was uncertainty regarding the upcoming leadership change in Washington and the looming Fiscal Cliff that will result in massive tax increases and spending cuts at the end of the year unless a compromise is reached between Democrats and Republicans.

The markets hate uncertainty.  Thankfully, the conclusion of November 6 elections finally puts all that uncertainty behind us, right?

Coming into the election, Democrats owned the White House (Barack Obama) and had a 53 to 47 seat (including 2 independents that caucused with the Democrats) advantage in the Senate while Republicans had a 240 to 190 seat majority in the House of Representatives.

After countless months of campaigning and a record estimated cost of $6-billion, what did the election accomplish?  Well Obama is still President, the Democrats held on to their majority in the Senate and the Republicans remain in charge of the House.  In other words: nothing.

Even worse, both sides feel they have received a mandate from the people to press for the changes they campaigned for.  Democrats feel President Obama campaigned on a platform of higher taxes for the rich and his re-election is evidence that the American people agree.

Republicans, counter with the fact that they held on to the House based on a platform of decreased spending and lower taxes for everyone, even the rich.  If both sides dig in their heels, we will be left with the same partisan gridlocked Congress as before the election with less than six weeks to go before their game of political chicken drives the U.S. and global economy into an economic recession.

But what if both parties get serious about making a deal?  The reality is the Republicans lost the election.  They know it, we know it, and the Democrats certainly know it.

Republican House leader, John Boehner has already indicated Republicans are willing to accept an increase in tax revenue from the rich, as long as it doesn’t mean higher tax rates.  It’s a subtle difference, but an important one for Republicans.

They would agree to capping or scrapping certain tax deductions such that tax revenue would increase, but they don’t want the actual rate to increase.  This appears to be their line in the sand.

For his part, President Obama knows entitlement spending needs to be contained.  He also knows that if he wants to get anything meaningful done in Washington before his second term is up, he has to work with the Republicans.  Obama no longer has to worry about getting re-elected – it’s now all about his legacy, or lack thereof.

We would never underestimate the negative impact politics has on the behavior of rational leaders, but we are optimistic that meaningful legislation can be achieved that will put the U.S. on a more stable fiscal path.

Even if a deal gets done, however, markets are likely to be volatile as both parties put on their negotiating hats in order to get the best deal they can.  It’s likely to be a high stakes game of brinkmanship, which is great for CNN, less so for investor nerves.

The Fiscal Cliff aside, the biggest factor cited by companies for missing third quarter earnings estimates was Europe. 

The average U.S. “big company” relies on Europe for 20% to 25% of their sales, and the European economy looks to be contracting.  The Purchasing Managers’ Index for the Eurozone fell to 45.7 in October; its lowest level since June 2009 and consistent with an economy shrinking 0.5% a quarter.

Even Germany is feeling the effects, with industrial production falling 1.8% in September.  The ECB recently lowered their forecast for Eurozone GDP growth in 2012 to 0.1% (let’s just call it flat) versus estimates of 1.0% in May.

The only good news coming out of Europe is Spanish and Italian bond yields have rallied such that both countries have been able to satisfy their borrowing needs for the year.  The threat of central bank buying has traders wary of taking short positions in either country’s bonds.

Just the threat of ECB President Mario Draghi’s OMT program (outright monetary transactions) has served to prop up demand for Spanish bonds such that President Mariano Rajoy seems to be in no hurry to apply for a bailout that would give the ECB the green light to buy “an unlimited amount” of Spanish bonds in the secondary market.  Why buy the cow when you can get the milk for free?

He already is getting the intended benefit of lower interest rates.  How much lower would the ECB drive rates?  If Spain applies for a bailout, they have to submit to the terms dictated by the ECB.  The market may eventually force Spain to go this route, but for the time being…. it’s free milk for Spain.

If the U.S. can avoid the fiscal cliff, a recovering U.S. economy should help drive domestic corporate earnings higher, despite what is happening in Europe.

This would be good for stocks, and potentially bad for bonds.

THE U.S. ECONOMY

Second quarter GDP may have come in at a modest 2%, but it was still more than expected and higher than the second quarter’s 1.3% increase.

It’s questionable how resilient growth is, however, as consumer and government spending accounted for much of the upside.  Manufacturing continued to move in the right direction with most regional purchasing manager indices either indicating expansion or moving towards it.

Of course Europe and the U.S. Fiscal Cliff continue to be a headwind and a big factor behind the IMF’s recent decision to lower their global growth forecast to just 3.3% this year and 3.6% for 2013.

The IMF puts the chances of a U.S. recession at only 15%, but believes there is almost an 85% probability of the Eurozone economy contracting.

Another good month for finding a job in October with 171,000 new positions created.

The unemployment rate moved slightly higher to 7.9% (more people looking for work) as President Obama becomes the second President since WWII to be re-elected when the unemployment rate exceeded 6%.

The private sector accounted for all the job gains with the retail sector adding just over 36,000 positions and the construction industry hiring 17,000 new workers, the most since January.

We are a little concerned with the higher Challenger Job-Cut Report, as lower earnings estimates are prompting large multi-nationals to cut expenses.  Also a concern is wage inflation, which dropped to zero last month.

There is no doubt the U.S is creating jobs, 25 consecutive months of positive growth in fact.  A healthier manufacturing sector and a recovering housing market all help.

The quality of the new jobs, however, is suspect.  Since the economic recovery started, 8.3 million Americans have taken part-time jobs, even though they would prefer to be working full time.  While the number of full-time jobs in the U.S. has declined by 5.9 million since September 2007, the number of part-time positions has increased by 2.6 million.

Not surprisingly, most part-time jobs are in low wage occupations like retail and food service, which alone have added 1.7 million jobs over the past two years.  To make things worse, starting in 2014 ObamaCare will require employers to offer a minimum level of health insurance to workers who work more than 30 hours a week.

Predictably, this is expected to incent companies to reduce the hours of certain low wage positions to less than 30 hours of work per week in order to avoid paying these extra costs.  In other words: creating even more part-time jobs at the expense of full-time positions.

Can’t you just picture Mitt Romney saying “I told you so”?

There is hope, however.  The U.S. Bureau of Labor Statistics estimates the U.S. will create 120,000 full-time jobs a year in high paying computer-related positions.

Unfortunately, the successful applicants will require at least a bachelor’s degree in computer science.  This is a problem since it is estimated all the universities and colleges in the U.S. put together only produce about 40,000 graduates a year in this field.

Inflation again crept a little higher in September, hitting the Federal Reserve’s target level of 2%.

Does this mean the Fed may be forced to tighten monetary policy in order to put the brakes on any building inflationary pressures?

Not likely.  In fact, several Fed officials have recently floated the idea of letting inflation run a little higher in order to reduce the perceived output gap that exists in the U.S. economy.  Certainly with an unemployment rate of nearly 8% and no wage growth, concerns over an increase in inflationary expectations would seem pre-mature.

The Fed, and most Politicians, will risk inflation if it means avoiding deflation.  They feel they can control inflation, but deflationary expectations are hard to reverse once in place.  Neither is good for the economy or capital market returns.

It’s why we own a little gold.

An improving job market and housing sector has consumer confidence on the rise. 

Predictably, higher consumer confidence is leading to stronger retail sales.  September retail sales increased 1.1% versus the previous month and 5.4% compared to the previous year.  October same store sales indicate the increases are likely to continue.

This is good and bad news for retailers.  Sluggish sales earlier in the year prompted retailers to cut back on inventory.  Durban Capital estimates that while Q2 sales were up 4.3% over last year, inventories increased only 1.9%.

The ports of Long Beach and Los Angles experienced 1.7% fewer incoming containers in July and August, a time when Christmas orders typically hits U.S. shores.  This could result in retailers running out of stock during the holidays.

Fortunately, volumes picked in September, even though it is typically a quieter month.

Higher consumer spending is good for the economy, but we are a little concerned Americans are taking their eye off the deleveraging ball. 

Also concerning is where consumers are choosing to spend their hard earned dollars.  Data recently disclosed by The Labor Department shows Americans have increased their spending on telephone services over the past four years while cutting back on other expenditures, like dining out, clothes and entertainment.

And it’s not just any phone that consumers are buying, its smart phones.  A new iPhone model can have a material impact on retail sales with J.P. Morgan estimating the new iPhone 5 could add 0.25% to 0.50% to GDP.  It’s one of the reasons retail sales in September, which is typically a slow month, may have been stronger than expected.

Of course, what’s good for Apple isn’t necessarily good for America and the increased spending in September could result in less spending down the road.  Especially as consumers wait for the new iPhone 5S (you know you want one!).

Existing home sales eased a little in September, but inventories remain low and prices continue to firm.  More importantly for the overall economy, housing starts and building permits are on fire.

The National Association of Home Builders estimates the building of one new home results in the creation of three new jobs and $90,000 in tax revenue.  It is clear the housing market is re-bounding, but investors want to know if the recovery is sustainable and if it is too late to invest in the sector.

We believe the answer to the first question is yes, the recovery is sustainable.  It doesn’t mean there won’t be bumps along the way, but household formation in the U.S. is recovering and the U.S. will need to build more homes to meet the demand.

The U.S. Census Bureau estimates 1.15 million new households were created in the year ending September versus only an average 650,000 annually the previous four years.   Even the sharp increases we saw in September housing starts would only add up to an annualized 872,000 new homes.

The answer to the second question is trickier.  Stock prices of home builders have rallied sharply as have the stocks of related suppliers.  While one has to be selective and price conscious, we still think there is upside left in certain housing related sectors.

The trade deficit widened in August as U.S. exports declined.  Higher oil prices were a major contributor, but global economic growth also played a large role.

The Netherlands Bureau for Economic Policy Analysis reported that it isn’t just U.S exports that are declining, but world trade in general, with global volumes falling 0.4% in August and September after declining 1.3% in June.  This is the longest losing streak since the five month swoon starting November 2008.

A recovering housing market and a stronger manufacturing sector should help drive job growth.  We are more positive on the domestic U.S. economy versus the global economy and continue to look for investment opportunities that will benefit from a recovering U.S. economy.

THE CANADIAN ECONOMY

A decline in August GDP is evidence the Canadian economy continues to decelerate.  Leading indicators are still positive and manufacturing indices still point towards expansion, but momentum is to the downside.

Finance Minister Jim Flaherty confirmed this view in late October by lowering his GDP forecast for 2013 to 2.1% from 2.4%, blaming weak commodity prices and a sluggish global economy.

October job growth came in lower than expected in October at just under 2,000 jobs, but the underlying trends were much worse.

Over 20,000 private sector jobs and nearly 15,000 self-employed positions were lost in the month and only the addition of nearly 37,000 government jobs prevented negative growth in the job market in October.  The good news is wage growth remains very strong, unlike in the U.S.

Inflation remains a non- issue in Canada.

Canadian consumer confidence and retail sales remained at healthy levels last month, which given the current household debt to disposable income ratio level, is probably not a good thing.

The much-watched ratio hit a high of 165.8% in Q2 versus 161.8% in Q1 and 161.7% last year.  While the trend is certainly not in the direction Bank of Canada governor Mark Carney would like to see it, the momentum has slowed as Canadians appear to be cutting back.

A recent RBC debt poll indicated 26% of Canadians are actually debt free versus only 22% last year with one in three Canadians indicating their debt level is causing them anxiety.

The Canadian housing market is putting up a good fight.  Sales rebounded from last month, but are still well off last year’s pace.  Prices remain firm.

Vancouver homes sales fell 33% according to the Vancouver real-estate board and prices are off more than 11% from their peak of April 2011.  The consensus view remains that the Canadian housing market will have a soft landing with price declines limited to the 10% range.

A U.S.-style meltdown is not in the cards unless interest rates spike higher or the unemployment rates surges.

Canada’s trade deficit narrowed in August due to a wide spread decline in imports.  An increase in energy exports to the U.S. helped minimize the decline in an export market that is being pressured by the slowdown in global growth.

We continue to believe a stronger domestic U.S. economy should impact Canada’s economy more than a slowing global economy.  A soft landing for the housing market is also required in order to keep consumer spending strong.

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