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North American Markets are Hot; European Markets are Not

Monthly Market Commentary | September 2012

Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

It was still “risk on” in September.

Bonds had a very good month with the NWM Bond Fund up 0.4%. High yield bonds have a little more risk, but also provided substantially more return in September with the NWM High Yield Bond Fund gaining 1.3%. A relatively flat Canadian dollar also provided a good environment for the NWM Global Bond Fund, which gained 2.0%.

Mortgages continued to provide steady returns in September, with the NWM Primary Mortgage gaining 0.4% and NWM Balanced Mortgage fund increasing 0.6%. Going forward, yields are 4.3% for the Primary Mortgage and 7.0% for the Balanced.

Preferred shares were up in September, with the NWM Preferred Share gaining 0.6%.

Canadian equities were higher in September with the S&P/TSX gaining 3.4% (total return, including dividends) while the Strategic Income Fund only managed a 1.6% 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 6.25%.

Foreign equities were also higher with all our external funds posting positive returns during the month. The NWM Global Equity Fund gained 2.7%.

Real estate was stronger in September with the NWM Real Estate Fund up 1.2%.

In Hedge fund world, gold bullion matched August’s 4.8% increase in U.S. dollars. In Canadian dollar terms, bullion was up almost 5%. Gold stocks reflected this strength, with the NWM Precious Metals Fund gaining 10.1%. With unlimited quantitative easing, gold looks to be moving even higher.

The NWM Alternative Strategy Fund was down 0.6% (estimated) in August.

SEPTEMBER IN REVIEW

By Rob Edel, CFA

Temperatures may have dipped slightly in September, but the markets were still hot with the S&P/TSX gaining 3.4%, while the S&P 500 and Dow rose 2.6% and 2.8% respectively. Year-to-date, the S&P/TSX is now in positive territory, up just over 3%, but the S&P 500 is up nearly 16.5%.

Of course, the big news driving the market higher was the new bond buying program (aka QEIII) announced by the U.S. Federal Reserve on September 13. Even though a move by the Fed was widely telegraphed, markets reacted quite favourably, with the Dow jumping 1.5% right after the announcement.

And why not? This was no ordinary quantitative easing. The Fed committed to buying $40-billion in mortgage-backed securities every month for – wait for it – as long as it takes to get the job market back to good health.

In addition, if the job market doesn’t improve quickly enough, the Fed may “undertake additional asset purchases.” It also pledged to keep interest rates “at exceptionally low levels” until mid-2015, versus late 2014 previously promised, but more importantly, it indicated investors should expect rates to remain near zero even after the recovery takes hold.

The Fed is not fooling around anymore: it means business.

Not only is it explicitly targeting the job market, but it has left the duration of the intervention open ended. What it did not do, however, is state the level of unemployment required for the program to run its course. Bank of America Merrill Lynch economist, Ethan Harris, figures an unemployment rate of 7% would do the trick.

Given most forecasts don’t expect the unemployment rate to dip that low until late 2014, the Fed could end up buying almost $1-trillion in mortgage securities. This kind of buying power would drive yields of these safe assets even lower, and hopefully force investors into riskier investments, like high yield bonds and stocks.

Will it work? In past quantitative easing programs, the positive impact has been temporary and returns have diminished with each successive program. But this is the beauty of QEIII: it is open ended, so maybe its impact on the market will be as well.

While this might lead to a sustained rally in the price of riskier assets like small cap stocks, safer assets like dividend paying stocks, have already been bid up in price by investors searching for yield.

Boring, slow growth sectors like telecommunications and utilities are now more expensive than the market, and almost as volatile. At the end of August, the 100 top dividend yielding stocks in the Russell 1000 index were nearly as volatile as the index as a whole and had a beta (a measure of price volatility versus an index) of .96 (versus 1.0 for the market).

Aggressive monetary policy is creating a valuation bubble in traditionally safe, low volatility assets, just like it did with the housing market a few years ago.  While quantitative easing may help investor sentiment, it is unlikely to increase corporate profits, which is what should be driving valuations.

A higher percentage of companies have been lowering their earnings estimates over the past several quarters. Bloomberg reports the current “bottom up” 2013 earnings estimate for the S&P 500 is $117, while the “top down” number strategists are forecasting for S&P 500 earnings per share is only $106.75.

It is not unusual to have a spread (individual stock analysts tend to lag the macro-savvy market strategists), but this is particularly wide. Normally when the spread diverges to this degree, the bottom up estimate converges down towards the top down estimate as individual company analysts sharpen their pencils.

Another risk with QEIII is excessive money printing, and expansion of the nation’s monetary base could lead to higher inflation down the road. It could also create a run on the dollar, which wouldn’t be a bad thing in the short term as a cheaper currency would make U.S. exports more competitive.

This fact hasn’t escaped the attention of central banks around the world, and many are likely to retaliate with their own monetary stimulus programs, like Japan did recently by increasing the size and duration of their own bond buying program by ¥10-trillion. Some fear the end result could be a currency war whereby competitive devaluation leads to higher and higher inflation.

So, is it time to take profit and head for the sidelines? Proponents of “Dow Theory” think so. According to this indicator, which dates back to the early 20th century, the transportation and manufacturing of goods should move in sync.

In a healthy economy, strong industrial demand will be reflected in the earnings of transportation companies that move the product to market. Weakness in the transportation sector can be an early indicator of future problems in the economy as a whole, which will be subsequently discounted in the stock market.

While the Dow Jones Industrial Average was up almost 3% in September and is approaching 5-year highs, the Dow Jones Transportation Average has been stumbling and is in negative territory for the year. While we are not big proponents of Dow Theory, the divergence is a concern.

Is the market going up due to the liquidity being injected by the Fed while the real economy rolls over? Yes and no. We think there are some positive signs in the domestic U.S. economy. It’s the global economy that looks to be slowing, and this might be what the transports are picking up on.

The economies of Europe and China continued to slow last month.

Manufacturing in the Euro-zone contracted for the 14th straight month in September, with a particularly steep decline in France potentially foreshadowing a contraction in the French economy. In the broader 27-nation EU, the ranks of the unemployed have swelled to more than 25 million, with more than 55% of Greeks and 52.9% of Spaniards below the age of 25 without a job.

Predictably, consumer confidence in the Euro-zone fell to a 40-month low in September. Manufacturing in China is also slowing, contracting for the 11th month in row, though September’s reading was incrementally better than August’s.

The advantage China has over Europe, however, is less government debt and more policy options than hamstrung European governments which have to plead their case to the conservative German Bundesbank. Look for more infrastructure spending to come out of Asian economies over the next several quarters.

Overall, QEIII should keep asset prices firm over the immediate future. Eventually valuations will need to rebalance and interest rates will have to move higher, but as ex-Citigroup CEO Charles Price once said, “As long as the music is playing, you’ve got to get up and dance.”

Diversification is your protection for this volatile investment environment with gold playing a role in protecting one’s purchasing power in a negative real interest rate world. The domestic U.S. economy still looks to be the least dirty shirts with which to dance.

The U.S. Economy

It was a mixed bag for the U.S. economy last month. Manufacturing, as indicated by the ISM Index, moved into expansion territory for the first time since May, but most regional indices were still contracting.

The services sector was also firmly in expansion territory, but durable goods orders were awful, suffering its largest pullback since January 2009. A large part of the decline was due to lower commercial aircraft orders, which tend to be very lumpy, but even excluding transportation, durable goods were down 1.6%.

Also lower was industrial production and leading indicators. Overall, we are pleased to see a recovery in the ISM manufacturing numbers, but the rest of the numbers point to slow GDP growth in the near term. A slowing global economy is a tough headwind to battle.

August was a decent month for the U.S. job market with 114,000 new jobs created, most of them in the private sector. More significantly, August and July’s numbers were revised higher to 142,000 and 181,000 respectively. Given this trend, we would expect September to gravitate in the same direction, especially since the ADP payroll number was significantly higher.

President Obama, of course, will be highlighting the unemployment rate, which dropped to 7.8%, below 8% for the first time since January 2009, and at its lowest level since Obama took office.

While the campaign commercials are sure to paint an optimistic picture, the reality is somewhat more muted.

The unemployment rate is derived from the household survey while payrolls come from the establishment survey. The household survey seeks to determine the number of people working, not the number of new jobs created.

While the household survey reported 873,000 more Americans were working last month, this total was merely the increase from the August total. Even a small margin of error can result in a big change given the size of the population being surveyed.

Also, 582,000 of the increase was attributable to an increase in part-time jobs. This is why the marginally attached and involuntarily part-time unemployment rate was unchanged. But President Obama won’t be telling you these facts. Nor will he mention that since the end of WWII, only one President (Ronald Reagan in 1984) has been re-elected when the unemployment rate has been above 6%.

Don’t worry though, Mitt Romney is sure to fill you in on all the details. The job market is getting better, but the improvement is glacial.

Inflation remains well controlled in the U.S. (notwithstanding the energy-induced spike in headline producer prices in August) and is one of the reasons the Fed is able to pursue an aggressive monetary policy.

This is not the case in other countries, however, especially the developing world, where food inflation plays a bigger role in the average consumer’s monthly budget. Wheat looks to be the latest food commodity to worry traders as prices have risen 35% since the end of May. Australia, which produces 16% of the world’s wheat exports, is suffering from a shortage of rainfall, as is India, while heat stress may prevent Russia from exporting wheat by November.

Both consumer indices moved higher in September, probably reflecting a firmer housing market. The average American has seen the value of their home increase 2.1% in Q2 and 4.3% year-to-date.

Overall household net worth declined 0.5%, but only due to a decline in financial assets. Given the recent run up in stock prices, we suspect overall net worth is now firmly in the black. While it is true that consumer confidence and home prices are still miles off their peak, the direction is clearly positive.

When Americans are confident, they tend to hit the malls, and August and September were no exceptions. August retail sales were respectable, though most of the gains were due to higher spending on gasoline and automobiles. Same-store sales in September were also encouraging, increasing nearly 4%.

A strong back-to-school season would normally bode well for the all-important Christmas season, however, the election and concerns over the fiscal cliff could take consumers’ eyes off the mall (sorry, couldn’t resist).

What is most remarkable about the strength in consumer spending is that it is happening at a time when the income for a typical U.S. family has fallen to levels not seen since 1995. Annual household income fell for the fourth year in a row in 2011, and while the poverty rate was unchanged, it rose every year from 2007-2010.

The Great Recession clearly did not kill the consumer culture in the U.S.. But there is hope. The children of Americans who have lost their jobs and homes are learning from their parents’ mistakes and are beginning to save their money.

According to Vanguard Group, participation rates for employees under the age of 25 in company 401(k) plans (the U.S. equivalent of RRSPs) hit 44% recently versus only 27% in 2003. Even better, Strategic Business Insight’s Macro Monitor reports only 45% of Americans under the age of 35 had credit card debt in 2010 versus 63% in 2002, and the balance for those that did fell to $4,100 compared to $5,100.

To quote the late Whitney Houston, “I believe the children are our future.” We may not have taught them well, but hopefully they will still lead the way.

September was another good month for the housing market. Existing home sales were strong and the inventory of unsold homes at 6 months remains at levels normally indicative of a balanced market, and considerably lower than the 12 months hit during the depths of the housing bust in the summer of 2010.

Accordingly, prices are also starting to rise, with the S&P/Case Shiller index in positive territory year-to-date, and up almost 6% versus last July.

There is still a chance the recovery may falter, however. The “shadow inventory” (foreclosed or soon-to-be-foreclosed homes) is still estimated to top 3.1 million homes, or 6% of the 50 million homes in the U.S. with a mortgage.

Even worse, 13 million homeowners still owe more than their homes are worth. We are moving in the right direction, however. While 3 million homes is a large number, the shadow inventory is down considerably from its peak of 4.5 million homes.

Helping clear the market are large institutional investors, like private equity funds. It is estimated private equity funds targeting foreclosed homes have raised $6- to $8-billion in capital, enough to buy 40,000 to 80,000 homes.

Distressed sales are also falling. At their peak, about a third of all sales were by distressed sellers. National Association of Realtors chief economist, Lawrence Yun, estimates distressed sales will fall to 25% this year and only 15% next year, which will further bolster home prices, given distressed sales typically take place at significant discounts.

The next few months are key as the market typically cools in the fall and winter months. But so far so good. The turn in the housing market is probably the most positive news story for the capital markets right now.

The U.S. trade deficit in July was virtually unchanged from the previous month with both imports and exports declining a similar amount. This is not a good sign and is clearly indicative of a slowing global economy. In fact, if not for lower energy prices, the large decline in exports would have resulted in a deteriorating balance of trade for the U.S..

The World Trade Organization recently lowered its estimate for the growth in global trade volume to only 2.5% this year versus previous forecasts of 5%. Global trade volume increased to almost 14% growth in 2010.

This is bad news for U.S. GDP growth, given Capital Economics economist Andrew Kenningham estimates exports have accounted for nearly half of all the economic growth during the economic recovery, such as it is. In past cycles, exports have played a much smaller role, only contributing an average of 12%.

We are still optimistic that exports will be a future driver for U.S. economic growth, despite what’s happening in Europe and Asia. The pie might not be getting bigger, but the U.S. is in a strong, competitive position to increase the size of its slice over the next few years.

The Boston Consulting Group recently highlighted that, as a percentage of the economy, U.S. exports are at their highest level in 50 years. Due to lower labour and energy costs, the U.S. is rapidly becoming the low-cost manufacturer of the developed world.

Boston Consulting estimates that by 2015, the U.S. will have a 5 to 25% cost advantage over Germany, Italy, France, the U.K. and Japan. After housing, this is probably the second most positive factor influencing the U.S. economy. Lower energy prices and an efficient labour force is making the U.S. a manufacturing power house. Invest accordingly.

The Canadian Economy

The Canadian economy continues to grow, but the momentum is definitely to the downside. Leading indicators were negative in August, and the Ivey and RBC purchasing manager indexes both weakened. Hardly surprising given the strong Canadian dollar and slowing global growth.

We thought August was a blow out month for Canadian job growth and this was as good as it gets. We were wrong.

September’s new job tally was 5 times larger than estimated and the largest increase in 5 months. Even better, almost all the new jobs were generated in the private sector.

In the past year, Canada has created 175,000 new full-time private sector jobs. The unemployment rate did tick up one tenth of a percent, but only because the labour force increased by nearly 73,000 workers.

Retailers were particularly busy, adding 34,000 new workers, while the construction industry created nearly 29,000 jobs, partially offsetting last month’s 44,000 loss. Hey, there’s no hockey on T.V., might as well get a job.

On a monthly basis, inflation moved back into positive territory in August. On a year-over-year basis, inflation moved slightly lower, confirming the view inflation is not a concern at the present time.

Canadian consumer confidence in September increased by its highest level since July 2011 and retail spending in July recorded a healthy increase. It seems Canadians are ignoring Bank of Canada Governor Mark Carney’s pleas for consumers to get their spending habits under control. We are a very impulsive bunch.

A recent poll conducted by the Bank of Montreal found Canadians spend $3,370 per year on things we want, but don’t necessarily need (I know, it’s all a matter of opinion — you need that new iPhone 5). 60% actually shop to cheer themselves up, and, sorry to say it men, males spend twice as much as females, splurging on items such as dining out (we hate to cook) and clothes.

So why is it the men’s department (tucked away in the basement) is a fraction the size of the women’s floors at most department stores? Just sayin’.

Home sales have noticeably declined in Canada leading to concerns the housing bubble is about to burst. Existing home sales declined by their largest margin month-over-month in August, and while prices haven’t start to fall yet, forecasters warn there is typically a 3- to 6-month lag between when sales begin to drop off and when prices begin to ratchet lower.

If there is a correction in the cards, Vancouver is destined to be at ground zero. September existing home sales in Vancouver plummeted nearly 33% versus the same period last year, and 42% below the 10-year average for September. Prices have also started to decline with the average residential prices down 6.9% year-over-year in August.

Canada’s trade deficit swelled to its highest level since Statistics Canada began keeping track in 1971, mainly due to a 8.5% decline in energy exports. Exports are a big deal for the Canadian economy and account for 20% of Canadian jobs and 63% of GDP.

As with the U.S. trade deficit, however, the fact that both imports and exports declined simultaneously is probably more indicative of a slowing global economy than a specific Canadian issue.

Some manufacturers and politicians point to the growing impact of oil exports on the soaring price of the Canadian dollar and suggest Canada is vulnerable to the effects of “Dutch Disease.” A recent study by the Bank of Canada refutes this notion, however. While higher oil prices may drive up the price of our dollar, the study concludes the overall impact for the country is “a net rise in income, wealth, and GDP in Canada.” It just so happens that it all takes place in Alberta (my words, not theirs).

We see some positive signs for the Canadian economy. Stronger growth south of the border will help Canadian exporters, particularly in energy and forestry. The job market is strong and our federal finances remain under control. The housing market and consumer debt levels continue to be our number one concern.

We believe the Canadian housing market is structurally different than the U.S., and while a correction is overdue, a housing bust like that experienced in the U.S. is unlikely. If we are wrong, however, a recession is sure to follow. Looks like the moment of truth is upon us.


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

Comments (1)

  • Ross Cowan said on October 23, 2012 @ 8:04 pm

    As a new client since May/12, enjoy your monthly comments.
    Would like to see more commentary on NWM Funds performance over more than just the latest month, eg. Q3/12 & YTD versus the benchmarks.
    Also, more future expectations about asset class relative performance movements provided by your Portfolio Management team.
    Ross Cowan, CFA
    Retired Equities Investment Analyst

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