The Tables Have Turned


Highlights This Month

Read this month’s commentary in PDF format

The NWM Portfolio

We are not market timers and do not tend to try and add value through tactical asset mix shifts. 

We believe economic growth will remain constrained over the near future as the world continues to de-lever.  We have positioned the portfolio accordingly by investing in cash flowing investments and having as much diversification as possible as we believe this will provide the best risk adjusted returns in this environment. 

Having said this, at the margin, we are presently looking to become a little more constructive on the equity markets in the short term.  In particular, we are deploying some cash to the U.S. markets as the U.S. economy looks to be on a firmer footing than the Canadian economy.  At parity, the Canadian dollar looks a bit expensive. 

We like defensive, dividend paying companies, but recognize that the market has caught on to this strategy and valuations are not as attractive as they were this time last year.  Adding exposure to more cyclical names has more upside over the short term.  We also like companies that are able to help companies and consumers cut cost, such as technology and generic drugs. 

Interest rates will remain low in the short term, but will eventually move higher.  As cash flow oriented investors, we are vulnerable to higher interest rates, though the duration on most of our fixed income investments is fairly short (bonds, high yield bonds, mortgages, etc.).  We are constantly looking for investments that can help us manage our interest rate risk. 

We also still like gold (though most of our clients have a full allocation).  With real interest rates at zero or even negative, gold should continue to move higher, regardless of what Warren Buffet says.   


January in Review

By Rob Edel, CFA

The markets started the New Year off right, with the S&P/TSX gaining 4.2% in January while the S&P 500 and Dow gained 4.5% and 3.4% respectively.

In early February, in fact, the Dow closed at its highest level since May 2008 and is a mere 10% from its October 9, 2007 all-time high while the NASDAQ is back to levels not seen since December 2000.  Commodities also rebounded sharply after correcting in the fourth quarter of last year.  Overall, it was “risk on” in January. 

A strong January bodes well for the rest of 2012, and the stars may be aligned in investors’ favor. 

According to Chinese astrology, 2012 is the year of the dragon.  Since 1900, the Dow has gained an average real return of 7.7% during dragon years, second highest of the twelve zodiac signs.  Don’t get too excited, however, the system isn’t foolproof.  The best years for the Dow historically have been the year of the Rabbit, and that was last year. 

Fittingly, the year of the Goat is the poorest year to be playing the market.  Thankfully, there is no year of the Bear.  

Certainly a stronger U.S. economy is helping move the capital markets higher, but the main factor is the realization that perhaps Europe is not going to implode and throw the global financial markets into a nuclear winter.  

The year’s not over yet, though.  There is still plenty of time for Europe to fall apart. 

 

 To be fair, the situation in Europe has calmed considerably. 

Yes, Standard & Poor’s downgraded the credit rating of France and eight other Euro-zone countries in mid-January – on Friday the 13th to be precise (who said credit analysts don’t have a sense of humor?).  But everyone already knew France wasn’t a AAA credit.  In fact, rather than creating a stampede out of French sovereign debt, French 10-year yields have subsequently moved lower.  

Same with most other Euro-zone debt.  The major concern last year was Italy, whose 10-year bond yield closed the year at an unsustainable 7.1%.  By the end of January, however, yields had fallen below 6% and continue to drift lower.  The ECB’s Long-Term Refinancing Operation (LTRO), where the ECB makes 3-year loans available to banks, has worked wonders as banks have borrowed from the ECB at 1%, only to turn around and invest in sovereign debt yielding upwards of 5 or 6%.  It’s a win/win.  

The downside is the ECB’s balance sheet has grown to €2.73 trillion, or 29% of GDP, its highest level ever.  This is very un-German-like and puts the ECB on a Federal Reserve style trajectory.

Of course, this is not to say that Europe’s problems are behind them.  Greece still needs to finalize a deal with private bond holders and legislate more austerity cuts in order to receive their latest bailout fix.  This will probably happen by the time you read this report and should take Greece out of the headlines for the time being. 

Portugal, however, is the leading candidate to replace them, with many speculating Portuguese bond holders will be required to take a haircut.  Portuguese bond yields reflect this pessimism.

 

So maybe it stops at Portugal?  Or perhaps Ireland?  The hope is Italy and Spain can avoid default, and maybe they can.  The problem, however, is all the solutions to the current debt crisis have centered on austerity measures designed to control budget deficits. 

Spending cuts typically lead to slower growth GDP in the short term, which leads to larger deficits.  It’s a downward spiral which eventually leads to ….you guessed it, default. 

The solution is growth.  Countries like Italy are not going to save themselves out of their debt problems.  Not with my money anyways.  It’s no mystery why some countries are experiencing credit crises while others are not.  Just look at economic growth and unemployment rates.  Germany and Switzerland, they’re doing quite nicely thank you.  Greece and Italy: not so much.

Now, however, even Germany’s economy is starting keel over, with retail spending falling an unexpected 1.4% in December.  Slower economic growth in Europe seems inevitable.  The pressure is off for now, but the problem remains.  We think we’ll be hearing from Europe again before the year is out.  Maybe even before the week is out.

 

Unfortunately, slower growth in Europe impacts the entire global economy.  As the Wall Street Journal’s Stephen Fidler recently mused, “Europe is not like Las Vegas: What happens here doesn’t stay here.”

The IMF recently warned that if European leaders don’t get a handle on the crisis soon, the IMF could chop a whole 2% off their estimated 3.3% global growth forecast.  Not only will demand for foreign goods be severely curtailed if Europe falls into recession, but so will capital investment in emerging economies. 

Already, European banks are repatriating capital from Eastern Europe and Asia in order to shore up weakened balance sheets.  Even mighty China saw its quarterly foreign-exchange reserve decline for the first time in more than a decade late last year and its trade surplus was at its lowest level since 2005.  

GDP growth in China continues to shift lower, coming in at 8.9% in the fourth quarter of last year and well below the average 10% China has grown over the past 30 years.  Europe would kill for such growth, but then they don’t have to create 20 million new jobs each year for workers moving to cities in search of a better life.  The stock market has taken notice, with the Shanghai Composite Index falling 21% in 2011. 

 

 
Who would have thought the U.S. would be the bright light for the global economy?
 

As we explain below (in painstaking detail) things are looking up for the U.S. economy.  Just to be doubly sure things keep getting better (it is an election year, you know), the Federal Reserve announced its intention to keep rates low (meaning near zero) until at least the end of 2014 and seemed to suggest another bond-buying program could be initiated if more jobs are not created. 

Chairman Bernanke even suggested higher inflation might be tolerated for a while if it would help get more Americans back to work.  Strange comments given what we consider to be improving economic numbers.  Either the Federal Reserve is just impatient or they know something we don’t.  We take these comments with a grain of salt.  If the economy strengthens meaningfully, they will raise rates, despite their previous comments. 

Rates will go up.  We just don’t know when.  Prepare accordingly.

 

 

  The U.S. Economy

At 2.8% growth in the fourth quarter, U.S. GDP put in its best showing in 18 months, cracking the 2% barrier for the first time in 2011.  While certainly stronger than third quarter GDP growth of 1.8%, it was still below expectations and GDP growth for all of 2011 was an anemic 1.7%.  Strong exports and inventory replenishment drove most of the growth while government spending was predictably weak. 

Overall, their economy is moving in the right direction, but many economists believe growth of 3% or more is needed in order to drive unemployment meaningfully lower.  This might be a stretch. 

 

Manufacturing continues to be the star of the show with purchasing manager indices in most regions pointing towards expansion and higher than readings in December. 

Globally, the U.S. manufacturing sector appears to be an oasis of growth with only India showing greater momentum in the manufacturing sector.  Fifty years ago news like this would have been all you needed to know about economic growth in the U.S.

Manufacturing accounted for 43% of GDP and employed a third of the private work force. 

Now, only 10% of workers toil in the sector and it represents only 28% of GDP.   It’s still important, but a recovery in manufacturing is not going to get the U.S. back to full employment, no matter how strong growth is relative to the rest of the world. 

 

  
 
Following up on December’s strong job’s report, January provided further evidence that the U.S. has turned the corner and the jobless recovery may be nearing an end. 

Depending on which survey you choose to believe, the U.S. added either 243,000 jobs in December (from the establishment survey) or nearly 500,000 (based on the household survey).  Either way, the news is good and the unemployment rate fell to its lowest level since February 2009. 

November and December’s numbers were also revised up a cumulative 60,000, indicating the surveys are behind the curve in keeping up with the current pace of increases in the job market.  For President Obama, the strength is welcome relief and just in time.  A weak Republican field and a declining unemployment rate have perhaps reduced the urgency for Obama to update his resume.  A second term is very much a possibility. 

 

It’s not all smooth sailing, however.  The number of workers unemployed for more than 6 months was unchanged at 5.5 million (or 43% of the total 12.8 million unemployed), as was the youth unemployment rate (16-19 year olds) at a staggering 23%. 

Hard hit sectors, such as the construction industry and manufacturing, are creating jobs, just not enough to replace the millions that were lost.  It’s unlikely they ever will.  Strength in January, and since the recession ended, has come from areas such as health care and professional and business services, a catch-all category that includes everything from accountants and lawyers to legal assistants and clerks (as well as janitors and restaurant workers). 

While there is the potential to create some high-paying jobs in some of these areas, it is suspected most of the gains have been low-paying jobs, like health care technicians or nurses’ aides, rather than doctors and nurses. 

 

One of the reasons job growth has been slow, is companies have opted to invest in capital equipment rather than increasing their payrolls.  Both monetary and fiscal policy is partially to blame. 

With interest rates at historically low levels, capital is cheap (monetary policy).  Temporary tax breaks enabling companies to write off 100% of their investments in year one are further enticing companies to bring capital spending plans forward and invest in projects that will help lower costs and increase productivity (fiscal policy). 

Since the recovery began in 2009, software and equipment spending has increased a blistering 31% while private sector jobs have increased only 1.4%.  Upgrading to the latest technology can go a long way to enabling companies to compete with low cost providers like China. 

Of course shipping jobs offshore is still a viable option.  With approximately 85% of the growth in U.S. multinational R/D jobs since 2009 being created outside the U.S., even high-tech jobs are at risk.  It makes sense to locate R/D close to manufacturing, but the fact that 56% of the world’s engineering degrees in 2008 were awarded to Asian graduates compared to only 4% to U.S. makes the decision a whole lot easier. 

 

  

Lower energy and vegetable prices have helped ease headline inflation over the past 6 months, but core PPI remains stubbornly high with December’s 0.3% increase the highest since July. 

While the Fed maintains their target CPI rate is 2%, as mentioned above, they also concede they would accept a higher rate for a period of time in order ensure the economy remains on a firmer footing.  Core CPI of 2.2% is not setting off any alarm bells at the Fed and gives them the green light to continue on their loose monetary policy path.

 

  

Consumer confidence was mixed in January with the University of Michigan consumer confidence index hitting an 11-month high while the conference board index moved lower.  A good set up for retail sales, which were also somewhat mixed.

 

December retail sales, while much better than last year’s depressed levels, missed expectations and barely increased from November. 

Excluding auto sales, December actually lost ground.   October and November probably stole some of December’s thunder with early Christmas promotions and sales enticing consumers to spend early and, hopefully, often. 

 

 
Particularly hard hit was electronics and appliance stores with sales declining 3.9%.  Brisk iPhone sales in November likely contributed to this decline. 

Looking forward, same store sales in January look decent, though January is generally considered to be a clearance month – and who doesn’t like a good sale?

The big question for the rest of 2012 is: how much disposable income are consumers going to have, and how much of it are they going to be willing to part with?  The temporary payroll-tax cut is estimated to have added 1.6% to a typical family’s disposable income. Despite the bi-partisan desire to extend it, this is not a given and it could expire at the end of February. 

The Bush Tax Cuts are another political hot-button issue and could expire at the end of 2012.  On top of this, J.P Morgan estimates that homeowners who have defaulted on their mortgages, but have not yet been evicted (and thus are living rent free) added perhaps half a percentage point to consumer spending. 

Even if disposable income growth manages to overcome these headwinds, who’s to say consumers won’t decide to do the prudent thing and save more?  Before December, the savings rate had been declining.  For consumers to continue to deleverage, they need to continue to save more. 

Hard to bet against the American consumer, but retail spending is unlikely to return to pre-recession levels anytime soon. 

 

  

 Home prices continue to move lower, but we are still hopeful the housing market in the U.S. has turned the corner.  Existing home sales have been moving higher and inventories have plummeted to nearly 6 months, a level historically considered to represent a balanced market. 

This is a big deal.  Low inventories should help drive new construction, which we are finally starting to see.  Even spending on home improvements is starting to pick up with HIS Global Insight estimating spending in 2011 increased 3.3% to $152.4-billion while a remodeling index compiled by BuildFax increased to 137.9 in November from 103.3 the previous year.   

 

Low interest rates, more jobs, an improving economy – they all help, but the most important factor making us think the housing market has bottomed: prices are cheap. 

According to National Bank’s Stephane Marion, based on the average household income required to qualify for a mortgage, a worker would only need to put in 1,600 hours a year, versus 1,850 hours one person works based on a 35-hour a work week.  This is the least number of hours required since 1965.  It also means a two family income is no longer required.

 

While we are optimistic, we expect the road to recovery will not be a straight line higher.  There are still a lot of homeowners whose homes are worth less than their outstanding mortgage and will be tempted to hand their keys back to the bank.  There are also banks that have already collected a lot of keys and are keen to sell.  It won’t be a quick recovery, but hopefully we have seen the worst.

 

 

The U.S. trade deficit widened for the first time in five months as the exports declined. While the U.S. economy has strengthened, Europe and China continue to slow.  Higher oil imports also drove imports higher. 

The Canadian Economy 
 
  
 

Not a lot of good news for the Canadian economy.  November GDP contracted a worse-than-expected 0.1% while leading indicators and manufacturing indices moved lower. 

It seems only a few months ago Canada was a bastion of stability and growth while the U.S. was mired in a jobless no-growth recovery.  The tables have turned.  A continued slowdown in China could put further pressure on Canada’s commodity dependent industries.  

Canada created a very disappointing 2,300 jobs in January, well below expectations.  Even worse, full-time jobs actually declined by 3,600 with part-time jobs more than accounting for the meager increase. 

The job market in Canada has come to a grinding halt.  Canada did create 129,000 jobs last year, but nearly all were in the first half of the year.  A recent CIBC report points out that not only did the quantity of jobs deteriorate, but the quality did as well.  The CIBC compiles an index based on three components:  full- versus part-time, self-employment versus paid, and wages of full-time jobs. 

While Canada created more full-time than part-time jobs in 2011, self-employment increased at twice the pace of paid employment.  This is bad for disposable income, because a self-employed worker typically earns 10-15% less.  As for wages, there were four low-paying jobs created for every high paying position. 

Tallying up the results, the CIBC figures real disposable income was unchanged for the first three months of the year, its worst showing in fifteen years.

Inflation continues to moderate with core CPI now below the Bank of Canada’s 2% target.  Lower gasoline and auto prices were the main drivers.  

 

Despite slower economic growth and very modest job growth, Canadian consumer confidence grew in December and retail sales were higher than expected in November. 

We remain concerned regarding the overleveraged consumer in Canada.  Canadians need to save more and a recent report by CIBC economist Avery Shenfeld supports this view.  The Canadian consumer debt-to-income ratio is not the highest in the world, in fact Shenfeld lists 7 developed countries with higher debt ratios than Canada. 

The concern is that since 2007, all the increase in debt has been attributed to the most vulnerable, namely those nearing retirement and those already heavily in debt.  In other words, those without good financial planning advice! 

It doesn’t mean a U.S.-style meltdown is imminent, but it does, at the margin, make certain Canadians more at risk to an increase in interest rates or unemployment.  Heaven help them if we get both.

  

Sales continue to increase, but prices have softened in the second half of the year and the CEOs of several Canadian banks recently expressed the view that prices may be peaking. 

This isn’t a bad thing, especially for the red hot Vancouver and Toronto markets.  Vancouver, in fact, was determined to be the second least affordable housing market according to Demographia International’s Eighth Annual Affordability Survey. 

What’s interesting about the Canadian Bank CEOs comments is, despite their concerns, they are doing everything they can to lend more money.  Several major banks were recently offering five-year fixed rate mortgages at 2.99%.  For the Bank of Montreal, who initiated the move, this was the lowest rate in their 195 year history. 

Banks are also loosening lending standards by making mortgages available to borrowers who don’t have to prove their income, typically the self-employed or recent immigrants.  Many fear this is moving in the same direction as the Alt-A, or “no documentation mortgages” in the U.S.

  

We do not think Canada is on the verge of a U.S. style correction.  

There are significant structural differences between the Canadian and U.S. housing markets.  Canadians do not receive a tax benefit from paying mortgage interest, our mortgage debt is non-recourse, and we require mortgage insurance for purchases where less than a 20 percent down payment is made. 

Most of the Canadian housing market is considered to be reasonably valued, with only Toronto and Vancouver being considered at risk for a correction.  The most likely scenario is a slow or no-growth market for a number of years.  We just don’t see interest rates spiking dramatically higher in the near future and, while we are concerned with the recent employment numbers, we don’t see the unemployment rate headed materially higher in the near term either. 

We would point out, however, that many in the U.S., including Federal Reserve Chairman Ben Bernanke, didn’t see a housing bust coming there either.  We are cautious of the housing market and, by extension, the Canadian consumer and the Canadian banking system.  The bubble may not burst, but we don’t see the growth continuing.

 

  

As rock band AC/DC would say, Canada was “Back in Black” in November as our balance of trade was a positive $1.1-billion versus October’s revised $500-million deficit.  Stronger exports, led by autos and energy powered our trade surplus higher. 

Overall, while Canada has had the fortune of being looked upon by the global financial world as wise and prudent compared to our southern neighbors in avoiding the worst of the financial crisis, the tables maybe turning slightly as the fortunes of the U.S. economy brighten while ours dim somewhat. 

Perhaps we are not the financial gurus we thought we were?

 

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