May In Review: Is China the Real Opportunity?


By Rob Edel, CFA

Highlights This Month

 

Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 1.0% in the month of May.  The NWM Core Portfolio is managed using similar weights as our model portfolio and is comprised entirely of NWM Pooled Funds and Limited Partnerships.   Actual client returns will vary depending on specific client situations and asset mixes.

Both Canadian and U.S. yield curves flattened last month, but mainly because long rates fell more quickly than short rates.  The impact on the NWM Bond Fund was muted, however, as the fund was flat last month.

The NWM High Yield Bond Fund gained 0.5% in May and is +1.9% year-to-dates. High yield credit spreads have widened slightly since the beginning of the year and are now at 362 bps above government yields versus the multi-year lows reached in January of 323 bps. The high yield market is still not cheap; however, particularly when credit spreads of distressed sectors (retail and wireline companies) are excluded. Because of this, the fund remains defensively positioned in an asset class that is prone to episodic volatility. The fund is earning 4.3% net yield, and has some long-short strategies (Picton Mahoney Income Opportunities, Apollo Credit Strategies) that can benefit in both positive and negative market environments.

The NWM Global Bond Fund declined 1.4% due to widening credit spreads (emerging markets & U.S. high yield market), interest rate exposure (Templeton’s long duration in EM and negative duration exposure in the U.S.) and negative currency impacts (EM currencies depreciated vis-à-vis USD$).

The mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund both returning +0.4% last month. Current yields, which are what the funds would return if all mortgages presently in the fund were held to maturity and all interest and principal were repaid and in no way is a predictor of future performance, are 4.5% for the NWM Primary Mortgage Fund and 5.5% for the NWM Balanced Mortgage Fund.  The NWM Primary Mortgage Fund ended the month with cash of $3.4 million, or 2.1%, while the NWM Balanced Mortgage Fund had $50.9 million in cash, or 10.4%.

The NWM Preferred Share Fund returned 1.3% for the month while the BMO Laddered Preferred Share Index ETF returned 1.5%.  The preferred share market mirrored most risk markets with a tail of two halves: increasing steadily at the beginning of the month before falling for the latter half as geopolitical risk weighed on markets. Four new issues came in May and we participated in two, Intact and National Bank. Intact raised $250 million with a 4.9% coupon and 255 basis points reset spread whereas National Bank raised $300 million with a 4.95% coupon and a 277 basis point reset spread. Demand for new issues remains robust, however institutional demand has dipped leaving retail demand to fill in the gap. Traditional bond and high yield managers are holding out for higher reset spreads (300 bps) before participating in any potential new bank deals.

Canadian equities were stronger in May with the S&P/TSX +3.1%. The NWM Canadian Equity Income Fund returned +2.3%. We are underweight in energy, materials, and technology which was a major source of the underperformance. We added Cargojet and sold Inferfor, Element Fleet, and Methanex. Top contributors to performance were Great Canadian Gaming, Aritzia, Heroux-Devtek, and Cott. Largest detractors were Sleep Country, Air Canada, and Rogers Sugar. Covered call writing is at 19% (vs. 24% last month). The target yield on the portfolio (including covered call writing) is 5.4%.

The NWM Canadian Tactical High Income Fund returned 0.0% in the month, significantly lagging the S&P/TSX’s +3.1% return.  The main reason for relative underperformance was due to being underweight energy, financials & materials. Option volatility dropped 9.4% in May; we are still taking a defensive view in the fund by trying to get to mid-to-high single digit annualized option premiums while also providing good downside protection. We sold the remaining position of Ag Growth International.  No new names were added.

The NWM Global Equity Fund returned +1.2%, matching the MSCI ACWI (all in CDN$).    Style (growth), sector (technology) and market capitalization mix (small cap) contributed to the fund’s overall results last month. Performance of our managers in descending order was Lazard +3.47%.  C Worldwide  +2.7%, Edgepoint +1.67%, ValueInvest -0.30%, BMO Asian Growth & Income -0.07%, and NWM EAFE Quant -1.5%.   In our NWM EAFE Quant, our overweight allocation in financials hurt as financials sold off -5.8% for the month. From a factor perspective, value has continued to underperform growth significantly as more expensive stocks had better performance for the month than cheaper stocks.

The NWM U.S. Equity Income Fund was up +2.5% versus the S&P500 which was up +2.4%.  The technology sector, which was up +7.4%, drove much of the index returns during the month.  The fund was underweight the sector (21.7% versus 25.5% in the S&P500), but stock selection in health care (Medtronic and HCA) and materials (Vulcan) more than offset this.  Constellation Brands (STZ) was a new name that was added to the portfolio; we took profits on two other consumer staples names, Estee Lauder and Costco, to fund this.

The NWM U.S. Tactical High Income Fund’s performance was 0.0% during the month versus a 2.4% increase in the S&P 500.  The fund’s underperformance was mostly due to being underweight technology; the info tech sector was up +7.4% during the month of May.

Market volatility dropped 21% intra-month but finished the month only down ~3%.

Put option writing was generally more challenging this month with annualized premiums in the high-single digits with similar downside protection.  The exception was Thor Industries (new name added) with mid-teen annualized option premium and ~10% downside protection.  Thor is the leading RV manufacturer in the U.S. with close to 50% market share.

In real estate, the NWM Real Estate Fund was +1.8% for the month of May vs. the iShares (XRE) +3.1%. The industrial sector continues to outperform. Dream Industrial REIT and WPT Industrial REIT are two small cap names that we hold that have had strong performance YTD. Both names were up 8% in May. Pure Multi-Family REIT, which was down 2%, was the poorest performer, but this was after a very strong April where the REIT was +17%. RUF-U announced that they are undergoing a strategic review to evaluate the potential sale of the REIT.

We report our internal hard asset real estate limited partnerships in this report with a one month lag.  As of May 31st, April performance for SPIRE Real Estate Limited Partnership was +0.2%, SPIRE U.S. Limited Partnership +1.1% (in US$’s), and SPIRE Value Add Limited Partnership +1.2%.

The NWM Alternative Strategies Fund was up +1.0% in May (these are estimates and can’t be confirmed until later in the month). A weakening Canadian dollar contributed 0.9% to returns. In local currency terms, Winton returned -1%, Millennium +1.2%, Apollo Offshore Credit Strategies Fund Ltd. +1.3%, Verition International Multi-Strategy Fund Ltd. +1.7%, RPIA Debt Opportunities +0.3%, and Polar Multi-Strategy Fund was flat for the month. For Verition, the largest contributor to returns for the month, main drivers of performance came from the fund’s quantitative strategies, contributions from their long short equity team (including a new portfolio manager who previously worked for George Soros) and their appraisal strategy. Precious metal stocks were flat to slightly negative to the month with the NWM Precious Metals Fund flat while gold bullion declined -0.4% in Canadian dollar terms.

May in Review

Investment returns were generally favorable in May, as both equities and fixed income provided positive returns.  For stocks, it was actually a very good month, with the U.S. benchmark S&P 500 up 2.4% (3.5% in Canadian dollar terms) and the Canadian S&P/TSX gaining a robust 3.1%.  Fixed income returns were less inspiring, but still positive, with bond yields falling and credit spreads relatively unchanged.  However, this doesn’t mean that all equity and fixed income markets were strong.  Europe and select emerging markets came under significant pressure last month, and even for North American investors, the ride was a little bumpy.  It’s not like last year, where volatility was very low and the market followed a nearly straight line upwards.  In 2017, the largest one day drop for the MSCI All-Country World Index (developed and emerging market stocks) was a mere 1.4%, and on only two occasions did it fall more than 1% in a single trading session.  So far this year, global stocks have fallen more than 1% on 11 separate days, the largest being a 2.9% drop.  Volatility has transcended investment markets as well, with geopolitical volatility also ramping higher.  Uncertainty appears to be the norm, with each day bringing a different challenge, or opportunity.  But does higher volatility mean investment returns will be lower?  Same for geopolitical risks?  In order to answer these questions, let’s look closer at some of the issues impacting markets and news headlines last month.

For investors, time can heal a lot of wounds, and ten years after the Lehman Brothers collapse, markets returns have largely put the financial crisis behind them.  Based on rolling 10-year returns, investors entering the market in June 2008 would have realized annualized total returns of more than 9%, only slightly below the nominal average since 1900.  After inflation, returns have been even higher than the long term average given inflation has been so low. The London Business School’s Elroy Dimson, Paul Marsh, and Mike Staunton peg real returns over the past 10 years at 7.8% versus the long term average at only 6.5%.  Technology has been the big driver of returns over the past several years and has been joined by a resurgent energy sector in 2018.  Earnings have also started to do their part, with first quarter profits for S&P 500 companies up over 26%.  Tax reform and a lower corporate tax rate are the main reason earnings are up double digits, and a long with higher oil prices and technology sector returns, are why U.S. stocks have outperformed Canada and the rest of the world this year to date.


It’s important to emphasize, however, that it’s not just tax reform driving the market higher.  The U.S. economy continues to strengthen, with the Atlanta Federal Reserve’s estimate for first quarter GDP growth presently well over 4.5%, easily the best quarter for growth in almost four years.  With the unemployment rate dropping to 3.8% in May and wage growth starting to finally gain traction, consumer spending should help lead U.S. economic growth even higher.  Wage growth has been disappointing during the nearly nine year economic recovery, but many economists believe we may be nearing an inflection point.  Workers are increasingly leaving their jobs voluntarily, historically a sign of confidence and for the first time since record keeping began in 2000, there are more vacant jobs in the U.S. than Americans actively looking to fill them.  While the headline unemployment rate reached pre-financial crisis levels in mid-2017, the broader unemployment rate, which includes marginally attached and involuntarily part-time workers, only hit pre-financial crisis levels last month.  Capital spending could provide an additional boost to growth, as cash rich companies invest in productivity enhancing projects.  According to NBER (National Bureau of Economic Research) data going back to 1854, the current economic expansion at 107 months and counting is only second in duration to the 10 year technology fueled 1990’s. We don’t see anything derailing growth before the second half of 2019 and preventing this expansion from becoming the longest on record.

Well, maybe that’s not quite true.  If growth is so strong that inflation moves materially higher and forces the Federal Reserve to raise short term rates faster than anticipated, the economic growth could come to an abrupt halt.  We just don’t see this happening this year, or even next.  In fact, the market odds of the Federal Reserve increasing rates three more times in 2018 (for a total of four given they have already raised rates by 25 bps once this year), fell from just over 50% to below 20% in mid-May.

So this is where things start to get interesting.  If growth was strong and equity prices higher, why were investors less optimistic over the Federal Reserve raising rates?  Because, while U.S. growth looks to be firming, global growth has slowed, particularly in the Eurozone.  The IHS Market Global Purchasing Manager’s Index fell to a nine month low of 53.1 in May, still in expansion territory, but well off its highs.  Another proxy for global demand, the Baltic Dry Index, has also come off peak levels, falling 22% in the past month.  Copper, often used as a barometer of economic activity, has also been weak.  On the whole, developed market economies have been coming up short of economists’ forecasts, as indicated by Citigroup’s Economic Surprise Index.  As a result of the relative strength of the U.S. economy, U.S. fixed income yields have been on an upwards trend while most other countries have seen their yields drift lower.  Same for their currencies.  Neither of these are sustainable situations.

As we mentioned last month, a stronger U.S. dollar puts tremendous pressure on emerging market countries that have debt and trade denominated in dollars.  In order to defend their currencies, some are forced to raise interest rates, thus slowing economic growth.  As a result, emerging market equities and fixed income prices have declined.

Not all emerging markets are created equal, however.  According to the World Bank, synchronized global growth is still intact and some emerging market economies are experiencing higher than expected growth.  Countries most vulnerable are those with high and growing external debt levels, current account deficits (the dreaded twin deficits), and low foreign exchange reserves from which to defend their currencies.  Turkey and Argentina check all of these boxes, which is why their currencies suffered the largest declines last month.  Argentina is trying to do the right things and has initiated many market friendly reforms, but raising interest rates to 40% in order to stabilize your currency and requesting a bailout from the IMF are typically frowned upon by investors in the short term.  We are less sympathetic towards Turkey’s plight given President Erdogen’s comment that he planned to become more involved in central bank policy following Turkey’s parliamentary elections on June 24th.  Mr. Erdogen was quoted as saying: “of course, our central bank is independent, but the central banks can’t take this independence and set aside the signals given by the president, who’s head of the executive”.  Say stupid things like this and people are going to sell your currency.

Speaking of saying stupid things, President Trump continues to do his best to keep markets on edge.  The North Korea summit is on, and then it’s off, then it’s on again.  It looks like we are getting close to a new NAFTA deal, then the U.S. goes ahead with the previously announced 25% tariffs on steel and 10% on aluminum.  Trump is now suggesting he would rather negotiate separately with Canada and Mexico.  U.S. Treasury Secretary Mnuchin states the trade war with China is on “hold,” and 10 days later Trump proceeds with tariffs on $50 billion of Chinese imports.  Finally, Trump proceeds with threats to pull out of the Iran nuclear deal, much to the dismay of everyone but Israel.  No wonder U.S. bond yields retreated last month.  Just one of these geopolitical issues going sideways will cause capital markets to panic.  The Donald has a lot on his plate, and not many friends.

We believe, for the sake of humanity, much of what President Trump says has more to do with his negotiating style than what he actually believes or will do.  Why slap a 25% tariff on steel, claiming it is due to security reasons when the biggest exporter of steel to the U.S. is Canada?    Both Canada and Mexico actually ran a trade deficit in steel with the U.S. last year.  Who are you trying to protect with tariffs on steel.  As a Washington Post article recently pointed out, the U.S. employs fewer steelworkers than it does manicurists and the steel industry in the U.S. represents less than 0.1% of the stock market.  As an input product for other industries, however, it is extremely important, and disrupting supply chains hurt U.S. economic growth.  Even the United Steelworkers union has opposed the tariffs on Canadian steel.  Predictably, Canada and Mexico have retaliated with tariffs of their own. We still believe Canada is not Trump’s real target, and probably neither is Mexico.

China is the real opportunity, and the biggest challenge.  From an economic and military perspective, China is the biggest threat to global U.S. hegemony. The $375 billion trade deficit the U.S. has with China makes it an easy political target, but the real facts are less clear. Coercing China to buy more American goods is not addressing the real issues, nor realistic. Even if China agreed to this, there are only so many goods China can buy from the U.S. in the short term.  Farm and energy goods have been targeted as products China might look to buy more of, but keep in mind total U.S. oil and soybean exports were less than $50 billion last year.  Even if Trump is able to engineer a lower trade deficit with China, it’s unlikely to increase the fortunes of American workers as the U.S. trade deficit with other countries would increase to compensate.  Not to bore readers with economic theory, but as long as the U.S. consumes more than it saves and needs to import capital in order to balance the books, a trade deficit will likely be the result.  Because the U.S. dollar is the world’s reserve currency, foreign investors are more than happy to buy U.S. Treasuries and help finance America’s budget deficits.  China has the opposite problem, it doesn’t consume enough.  Both countries need to rebalance, but it won’t happen overnight.  Also, trade numbers don’t always capture the true underlying trade taking place between countries.  According to JP Morgan’s Michael Cembalest, the U.S. trade deficit with China nearly disappears if sales of U.S. subsidiaries doing business in China are included in the totals.  This doesn’t help American workers, but it does contribute to U.S. corporate profits.  The fact many of these U.S. subsidiaries are forced to partner with Chinese companies and give up their intellectual property in order to get access to the Chinese market is where the real battle needs to be fought.

Perhaps the biggest market mover last month had nothing to do with President Trump, but was a return to the headlines for our old friend the Eurozone.  This time it was Italy’s turn to take the spotlight as Italian bond yields spiked higher and investors were left thinking, Momma Mia, here we go again! With intrigue matching the Meryl Streep musical sequel out this summer, Italy’s two upstart populist’s political party’s attempt to form a government was initially squashed by Italy’s President.  The left leaning anti-establishment Five Star Movement and the hard-right League Party were an unlikely coalition to start with.  Sort of like Bernie Sanders and Donald Trump agreeing to team up.  What bound them was a dislike for the Euro and the European Union along with a plan to increase spending to appease the left while simultaneously lowering taxes to appeal to the right.  Of course, none of this appealed to investors or other EU governments, especially Germany.  Italy’s appointed President Sergio Mattarello, who needs to approve the government before it takes power, drew the line at the appointment of Eurosceptic Paolo Savona as Finance Minister and asked former IMF Official Carlo Cottarelli to try and form a government instead, which he had zero chance of successfully doing.  In fairness to President Mattarello, Savona was a bit of a non-starter given he had recently compared Germany’s role in setting Eurozone monetary policy to that of Nazi Germany aggression during WWII.  The problem, however, was that in rejecting the new government, Mattarello was likely sending Italians back to the polls with the future of the Euro likely being the main campaign topic.  In the end, an alternate finance minister was chosen and the new left-right coalition will take power, for now, but their relationship with Germany and the rest of the EU will likely be strained. The EU can’t allow Italy to increase its budget deficit, but they also can’t let Italy default or leave the Euro.  The threat of either happening sent European bank shares and the Euro sharply lower.  In a flight to safety, investors bought German Bunds and U.S. Treasuries, lowering the yields on both.

We continue to believe the current economic and political structure of the Eurozone is unstainable.  In the short term, however, the political situation in Italy should calm down.  Quite frankly Italy is too big to fail.  It has too much debt, with a lot of it sitting on the balance sheets of European banks.  As much as Italy’s new populist coalition might like to ditch the Euro, doing so would destroy the savings of the very people who voted them into power.  As both the EU and the left-right coalition come to the realization they need to work together, markets should begin to normalize.  In the meantime, the situation has helped provide a little bit of a breather for U.S bond yields that were continuing to march dangerously higher in early May. We believe rates should and will drift higher as the economy grows and the Federal Reserve continues to remove monetary stimulus, we just don’t want it to happen too quickly.  The threat of trade wars provided a similar breather for bond yields. Even if a trade war happens, it might be bad for global growth, but given the U.S. economy is less exposed to trade than most countries, the impact should be contained.  Canada is more exposed, though not as much as Germany.  We believe common sense will eventually prevail, and the fact bond yields have moved lower in the short term as investors look to the safety of U.S. Treasury’s is good for the markets.  We would become more concerned if the uncertainty leads to lower capital investment as we believe business spending is poised to become the next driver of U.S. growth and will help extend the current economic cycle.  Call us naively optimistic, but we believe/hope Trump is just using tariffs as bargaining chips and won’t actually blow up the global economy.

Same for blowing up the world for that matter.  Some analysts believe Trump is pressuring China on trade in order to coerce China into helping bring North Korea to the bargaining table and solving perhaps the biggest geopolitical risk facing the U.S. and the world.  It’s quite likely withdrawing from the Iranian nuclear deal is also related.  The U.S can’t expect North Korea to accept a worse deal than Iran got can they?  Maybe putting pressure on Iran will also bring them back to the negotiating table?  The press is more than ready to point out Trump’s flaws and mistakes, of which there are many, but this is not new.  A recent poll by Axios found 45% of Americans and 87% of Republicans believe the news media has been too critical of Trump.  Even if he is unsuccessful, will we be in a worse position than before?  What if he succeeds?  Think glass half full people, because the alternative is unimaginable.

 

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information presented here has been obtained from sources believed to be reliable, but not guaranteed. Returns are quoted net of fund/LP expenses but before NWM portfolio management fees. Past performance is not a guarantee or a reliable indicator of future results. All investments contain risk and may lose value. Please speak to your NWM advisor for advice based on your unique circumstances. NWM is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions. This is not a sales solicitation. This investment is generally intended for tax residents of Canada who are accredited investors. Please read the relevant documentation for additional details and important disclosure information, including terms of redemption and limited liquidity. Nicola Crosby Real Estate, a subsidiary of Nicola Wealth Management Ltd., sources properties for the SPIRE Real Estate portfolios. Distributions are not guaranteed and may vary in amount and frequency over time. For a complete listing of SPIRE Real Estate portfolios, please visit www.nicolacrosby.com. All values sourced through Bloomberg.