The Pain in Spain Falls Mainly in Germany


Highlights This Month

Read this month’s commentary in PDF format.

The NWM Portfolio

Overall, May was a “risk off” month, with most asset classes losing ground.

The exception, of course, was bonds, which were higher with the NWM Bond Fund ending up 0.5%. Short-term Canadian Government bond prices increased with 2, 5, and 10-year yields decreasing.

We still believe rates will move higher at some point and have added a new manager to the NWM Bond Fund, but as long as Europe remains under pressure, rates could stay low or even move lower in the short-to-medium term.

Canadian equities were lower in May with the S&P/TSX losing 6.3% (price return not including dividends) though the NWM Strategic Income Fund (SIF) managed to end the month down only 4%. Year-to-date the S&P/TSX is down 3.7% (-2.5% including dividends) while the Strategic Income Fund is up 1.0%.

We have used the recent correction in energy stocks as an opportunity to add to our core positions. We have elected to not write options against our energy and commodity holdings at these levels but have used the recent increase in volatility as an opportunity to write call options against some of our defensive names that have held up in the current market volatility. Our running yield in the SIF is just under 6.25%.

We continue to monitor the Canadian banks. Their exposure to the Canadian housing market and global economy (particularly Europe) makes us wary of increasing our positions. On the other hand, they continue to pay healthy dividends and have strong capital positions.

MAY IN REVIEW

By Rob Edel, CFA

Equity markets went from bad to worse in May, with the S&P/TSX and S&P 500 losing 6.3% – the worst stumble for equities since May 2010.

The sell-off was very broad with nine of the S&P 500’s ten sectors declining. Only telecom services managed to buck the trend. The old saying “sell in May, come back on St. Legar’s day” (second Saturday in September) has certainly been prophetic the last couple of years, and looks to be on track again this year.

While stocks were going down, bonds were headed higher (yields down, prices up), though not all bonds. Countries considered safe havens – mainly the U.S., Germany and Japan – saw capital flow into their government bond markets resulting in yields falling to historic lows.

On the other hand, Southern European countries (particularly Spain) saw capital flee their banks for safer harbor elsewhere, driving yields higher. Some of these moves we understand – others, not so much.

We get why money is flowing into Germany, which recently issued a 2-year bond that effectively pays no interest.

If the Euro falls apart and Germany reverts back to the Deutsche Mark, investors will likely benefit from an appreciating currency versus whatever ever country they are seeking refuge from. Who cares about interest payments? They want their principal back, and in a form that is worth at least as much as it is now.

If the Euro doesn’t fall apart and Germany is faced with a future of funding continuous bailouts, German bonds denominated in Euros paying no interest could prove to be a poor safe haven.

Will the Euro fall apart?

We are optimists by nature (no really, we are!) and believe/hope feverish negotiations are presently taking place behind the scenes in Europe to create the framework for a Federalist system such that the present monetary union would be matched with fiscal or even political union.

Longer term, a fiscal union needs to happen. Time is the problem. These are big changes and will require treaties to be renegotiated and signed.

In the meantime, the economies of Europe are contracting, or at least most of them. Safe haven Germany, which accounts for 30% of the Eurozone economic output, grew a respectable 0.5% in Q1 for an annualized increase of 2.1%. Not great, but respectable. Spain, on the other hand, contracted 0.4%, and Greece declined a frightening 6.5%.

The people are growing restless.

By the time you read this comment, the Greek election (June 17) will be history and a new government will hopefully be chosen. Many fear the Syriza Party, which has momentum from the last election and has been polling very well, will garner the most votes and win the 50 bonus seats in the 300 member Parliament (yes, you read that right) as the largest party.

Once in power, Syriza has threatened to renegotiate the bailout package, which would likely result in Greece exiting the Euro. I suspect the average Greek voter doesn’t really think the radical left or extreme right would do a better job at running the country.

On a recent morning Greek television program, a member of the neo-nazi Golden Dawn party was seen throwing a glass of water at a Syriza party member before striking a Communist party member in the face several times.

Good television if you’re a fan of Jerry Springer, but hardly the conduct one wants to see from their elected officials. (I don’t know who’s cheering “Yeah, let’s elect these guys!”)

Maybe they can knock some sense into German Chancellor Merkel. Most Greeks (up to 80% according to recent polls) want to stay in the Euro and probably only supported anti-austerity parties like Syriza in protest over the economy and recent austerity measures.

Even the leaders of the Syriza party appear to want Greece to stay in the Euro and seem to be playing a giant game of chicken with Germany in order to gain concessions from the severe austerity measures stipulated in the bailout agreement. It won’t work.

Germany wants Greece to stay in the Euro, but they won’t budge on the bailout plan. They can’t. German voters won’t let them and any concessions would be used by other Euro countries as an excuse to shift away from labour reform and austerity themselves.

Germany will call their bluff and Greece will be out. Hopefully, Greeks will support leaders in favour of reform and stay in the Euro. We think they will, but since Greek law doesn’t allow polling up to two weeks before an election, no one really knows how it will turn out. Needless to say, the markets will be very volatile leading up to June 17th.

Investors are concerned about Greece, but let’s face it: Greece has been a slow motion train wreck for a while. Many financial institutions have already positioned themselves for a potential Greek exit from the Euro such that the fallout, while painful, should be manageable.

Spain, on the other hand is a bigger problem.

Spain’s economy is reeling from the collapse of a decade long housing bubble and its economy is expected to contract nearly 2% this year. Rating agency Finch recently downgraded their credit rating three notches to BBB.

The Spanish unemployment rate is approaching 25% and retail spending has declined 22 straight months and most recently plummeted 9.8% in April alone. Even worse, government bond yields have spiked higher again, threatening to eliminate Spain’s ability to borrow money, which is a problem, because Spain needs money.

Many of Spain’s banks are saddled with bad real estate loans and have to be recapitalized. Spain’s recent bailout of Bankia SA (the third largest bank in Spain) with a €19-billion capital injection was well received by the capital markets until questions were raised about where Spain would get the money from.

The IMF estimates Spain might need to set aside nearly €40-billion to cover bank losses. Other estimates have pegged the total at nearly €60-billion. Looks like Spain will be needing a bailout (and got one in early June, but more about that next month).

Given the problems in Greece and Spain, we get why money is moving out of Greek and Spanish bonds and into German bonds.

Germany is still part of Europe, however, and is hardly immune from the problems facing countries like Greece and Spain. But if not Germany, where else does an investor go for protection?

Enter the U.S. dollar and the most liquid security in the world: U.S. Treasuries. Clearly the U.S. is less exposed from the current crisis than Germany, but it is still vulnerable to a global debt crisis and, as we will describe below, the U.S. economy looks to be slowing once again.

The Fiscal Cliff (or as it’s been called it in the past, “Taxmageddon”) refers to looming tax and spending changes, including the expiry of the Bush tax cuts and payroll tax deductions. These are due to take effect in early 2013 and will further test the U.S. economy.

And to make things even more fun, it’s likely the U.S. will need to increase its debt ceiling again in late 2012 or early 2013 after raising it by $2-trillion just last August. Good luck getting the current dysfunctional political system to pass anything before the November elections.

Our best hope is secret talks (rumored to be taking place) will narrow the current gap between the tax increases the Democrats want and the spending cuts the Republicans demand and a bill can be quickly passed right after the November elections.

Another Quantitative Easing program is also possible, though with interest rates so low, we’re not sure what the purpose would be. Europe has basically done the Federal Reserve’s job for them with safe haven money driving interest rates lower.

Other than to calm the equity markets at the expense of inflating the Federal Reserve’s balance sheet, the only other benefit would be to lower the U.S. dollar, which has been surging and will begin to weigh on U.S. exports. For this reason alone, you can’t rule out more money printing.

Another advantage America has in terms of being a safe haven is that, demographically, the U.S. is one of the few developed counties in the World to have a birth rate at or above replacement level of 2.1 children per couple. Even emerging countries like China and Brazil are below replacement levels at 1.9.

Longer term, if the U.S. can alleviate their fiscal problems with tax increases and entitlement spending cuts before the bond market cuts them off, the U.S. may indeed prove to be a safe haven.

Now Japan as a safe haven, we don’t get. We understand Japan is a key international reserve currency, we just don’t understand why. While it’s true that Japan has typically run a healthy current account surplus, their debt-to-GDP is well over 200 percent – highest of all industrialized nations.

At over ¥1-quadrillion (how many zeros is that?), which is the equivalent of approximately $14-trillion U.S., Japan owes about as much as the U.S. government, except the U.S. economy is twice as big and is actually growing.

Last year, Japan posted a trade deficit for the first time since 1980, and while the tsumani/earthquake was likely a big factor, the strong yen and rising energy imports are likely to weigh on Japan’s balance of trade in the future.

Also, unlike the U.S., demographics are working against Japan. With a birth rate of 1.3, well below replacement level, Japan could turn from a nation of savers into a nation of borrowers and spenders in the relatively not too distant future.

Rating agency Finch would seem to agree, downgrading Japan’s sovereign debt rating to A-plus, in line with such credit stalwarts as Estonia and Malta.

The one thing Japan does have going for it, however, it its close proximity to the emerging economic power house, China. If free flow of capital were allowed in China, it is likely they would join Germany, the U.S. and Japan as a safe haven.

Like these three, however, China is not immune from the global slowdown. China’s industrial output in April slowed to its lowest level since May 2009 and electricity output, perhaps the best indicator of economic activity in China, increased a mere 0.7% year-over-year, the slowest increase in three years.

China has a lot of levers to pull in order to avoid a hard economic landing, however, and they are starting to pull them. After lowering bank reserves ratios for the third time in six months in mid-May, China took the more dramatic step of lowering borrowing rates 25 basis point in early June, the first such change in rates since 2008.

In addition, China’s National Development and Reform Commission has approved 868 new investment projects in the first four months of the year, more than twice the number approved during the same period last year.

While it is true China will be impacted by a slowing European economy (China’s exports to Europe total approximately 3.6% of GDP in 2011, while U.S. exports to Europe totaled about 1.3% of U.S. GDP), infrastructure and capital investment accounted for half of China’s economic growth last year with net exports contributing nothing.

China doesn’t rely on foreign investment for capital as its citizens have a savings rate of 51%, and unlike Japan, government debt is a modest 25% of GDP, with local government debt pushing the total to maybe 50%. Unlike Spain, its banks are very liquid with deposits more than matching loans and reserves.

All in all, China is a pretty clean shirt.

Turmoil in Europe, a slowing U.S. economy, and the threat of a hard landing in China – lots of bad news and plenty for the world to worry about.

How about some good news! Archaeologists from Boston University have recently discovered a small building in the ancient Mayan city of Xultun in Guatemala. As many of you are aware, the ancient Mayan calendars appear to end on December 21, 2012 leading some to speculate the Mayans believed this to be the date the World would end.

On the walls of the newly discovered Xultun building, however, Archaeologists have uncovered deep time calendars that can be used to count thousands of years into the past and future, thus debunking these doomsday prophecies.

We are rebalancing portfolios accordingly.

 

 

The U.S. Economy

Q1 GDP was revised lower in May and most manufacturing indicators, while still indicating growth, were weaker. Slowing growth is better than no growth, but many fear that is where the U.S. is headed given a looming recession in Europe.

Exports, however, comprise less than 15% of the U.S. economy versus 40% for Germany and 30% for China. Barring any U.S. political missteps, we think U.S. economic growth will be slow, but positive.

Another disappointing month for the job market with just under 62,000 jobs created, less than even the most pessimistic estimate. Even worse, March and April, which were already disappointing, were revised a combined 49,000 jobs lower.

The hope is seasonality adjustments took a larger toll than justified, given the raw number (non-seasonally adjusted) reported an increase of 800,000 jobs. Also contributing to the recent string of poor job reports is likely the warm winter weather that likely resulted in strong hiring earlier in the year to the detriment of the current spring months.

Even so, the job market has gone from one of the potential bright spots for the U.S. economy earlier in the year, to a big disappointment and source of concern.

Even those who have been lucky enough to keep their jobs are discovering it’s tough to keep up, given wage growth has been virtually stagnant. Since 2010, the manufacturing industry has created 489,000 jobs. Wages, however, are 3.2% below their March 2009 peak and are back to their 2000 levels if adjusted for inflation.

This is good for employers and is one of the reasons manufacturing is making a comeback with an estimated 25,000 jobs having been brought back to the U.S. over the past few years. The bad news is wages in China pay around $3.50 an hour versus around $15 an hour in the U.S., meaning U.S. could be stuck in the doldrums for years to come.

Inflation continued to ease in April, giving the Federal Reserve a green light if they decide further monetary stimulus is needed. The core inflation number, however, remains stubbornly above 2% as most of the decline in the headline figure is due to a decline in energy prices, with crude oil prices slumping over the past few months.

The relative stability of the inflation rate is somewhat surprising to some economic forecasters, though not always for the same reasons. Some fear the expansion of the Federal Reserve’s balance sheet will lead to rising inflation, if not now, at least at some point in the future.

However, because the money multiplier (the rate at which money is exchanged from one transaction to another) has declined, an increased monetary base has not resulted in prices being bid up. Alternatively, many feared inflation would plummet given the slack in the economy and especially the labor force.

While, as mentioned above, wage growth has been virtually non-existent and new jobs have typically not paid well, employers are reluctant to actually cut wages. Also, consumer inflationary expectations have remained remarkably consistent.

Consumer confidence was mixed in May, with the Conference Board index falling to its lowest level of the year while the University of Michigan index soared.

April retail sales were predictably weak, but same store sales in May were pretty good as the record warm weather in the U.S. continued to lure consumers to the malls. With wage growth stagnant, the increased spending is coming at the expense of the savings rate, which hit a four-year low in April. Good for the economy, but not sustainable.

While the recovery in the job market looks to have stalled, the prospects for the housing market continue to brighten.

New and existing home sales were strong in April and prices look to be holding as distressed sales comprised a smaller percentage of the total. On a seasonally adjusted basis, the S&P/Case Shiller index reported prices in March increased on a month to month basis for the first time in two years.

Not all markets are created equal, however. Atlanta, Chicago, Las Vegas, New York, and Portland all hits new lows in March with Atlanta down 17.7% versus last year. Phoenix, on the other hand, was up 6.1%.

Maybe – and we stress the word maybe – the housing market has bottomed. But don’t expect a rapid recovery. There are still a lot of homeowners struggling to keep their homes out of the bank’s hands and a large number of homes that still need to work their way through the foreclosure system.

Almost 12% of all mortgage loans were at least 30 days in arrears or in foreclosure in March. This is better than the 14.7% total two years ago, but still a worrisome number.

The deterioration in the trade deficit in March highlights the recent strength of the U.S. consumer as import growth soared, particularly imports for China.

Overall, the U.S. economy continues to slow. Maybe it’s slowing because it grew too fast during the warm winter months; maybe it’s due to concerns regarding Europe. Regardless, we don’t think the U.S. is headed for a recession, but the trend is of concern.


The Canadian Economy

GDP growth was unspectacular but positive in March and the Q1 estimate was revised slightly higher. More dramatic was the increase in purchasing manager indexes with both the RBC and Ivey PMI’s well above 50.

Statistics Canada reported shipments from manufacturers rose 1.9% in March, the strongest growth in six months. Unfilled orders hit a three year high and factory sales were up 5.9% over last year. Aerospace, chemicals, and automobile were some of the industries benefiting.

Perhaps the strong Canadian dollar is not the drag on manufacturers that we thought it was?

Canada’s May employment report came in as expected with a modest increase anticipated after April’s blowout month. The report was of a lower quality, given 23,300 self-employed positions were created and almost an equivalent number of private sector jobs were lost.

The manufacturing industry gained 36,000 jobs while the construction industry lost 27,000 jobs, reversing last month’s gain.

Like most developed countries, the youth in Canada have suffered more from the financial crisis than the average worker. Of the 6.8 million Canadians between the ages of 15 and 29 years of age, 13% (or 904,000) weren’t at school or working.

While this is a disturbing statistic, of G7 nations, only Germany at 11.6% has a lower percentage. Italy leads the pack at 21.2% (based on 2009 numbers). Interestingly, of the 904,000 idle Canadian youths, only 391,000 were actually looking for work and only 55,000 have been looking for more than six months.

Inflation moved slightly higher in April and core inflation is now slightly above the Bank of Canada’s preferred 2% target.

The Bank of Canada would like to raise interest rates and probably would have done so already if not for events unfolding in Europe. With the Canadian dollar falling below parity, the Bank of Canada has even more leeway for moving rates higher once the capital markets settle.

Consumer confidence and retail sales are both on the upswing in Canada.

Prices in Vancouver were off 10% versus last year, as the over-heated Vancouver market finally looks to be cooling.

Most other markets were stronger, however, led by Toronto with sales up 2.5% and prices up 8.4% – another reason why the Bank of Canada would like to increase interest rates.

When Vancouver prices skyrocket it’s an interesting news article. When Toronto (aka the center of the universe) prices become a problem, it’s time to take action.

Canada’s balance of trade remained in the black in March, but the fact that both imports and exports declined is more of a concern than a reason to cheer. Lower energy prices were a big contributor to the lower decline in exports.

The health of the U.S. economy is a big factor in what happens to Canada. In 2011, the U.S. accounted for 67.7% of Canada’s imports and export business. While this is a big number, it is down from 80.8% 10 years ago. Filling the gap is trade with Asia, particularly China. A decade ago, Asia represented only 9.5% of Canada’s trade versus 15% last year with China alone accounting for 7.2%. For the first time ever last year, B.C. sent more goods to Asia than to the U.S.

The Canadian economy continues to outperform. We were concerned earlier in the year when it looked as if the Canadian economy was slowing relative to the U.S. economy. Now the reverse is true.

If it weren’t for the fact that the Canadian market is so small, Canada would make a great safe haven. Healthy labour market and relatively strong fiscal position, the envy of any global economy. The Canadian dollar traded lower in May, but that’s most likely due to lower oil prices, which is strongly correlated to the Canadian dollar.

Going forward, while Canada is doing more business with Asia, the U.S. economy is still the major determinant for the direction of our economy and the jury is out whether that is a good thing or not.

What’s your reaction to market activity during the month of May?  Let us know in the comments below!