By Ben Jang, CAIA, CIM, DMS
Highlights This Month
- Three headlines that dominated April’s market news.
- The taller they stand the harder they fall.
- U.S. consumer spending is looking up.
- Actions speak louder than words when it comes to the OPEC.
- Foreign investors eye-up Canadian real estate.
- Investors are reassessing CAD vs USD.
- What the U.S. Treasury’s proposed tax inversion regulations mean for M&A.
- Negative interest rates – what does it all mean?
The NWM Portfolio
Returns for NWM Core Portfolio increased 0.3% for the month of April. 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.
NWM High Yield Bond was up 1.4% in April, with positive high yield bond returns partially offset by the fund’s U.S. dollar currency exposure. As investors continued to return to the high yield market in April, yields continued to compress (8.1% at month end) compared to its mid-February peak (10.4%). With more palatable financing yields, corporate borrowers also returned to re-balance the high yield market—new issuance of bonds in April was higher than total new issuance for the first quarter.
Lower-quality CCC and commodity credits outperformed the rest of the high yield market sharply in April. However, high yield remains a tale of two markets, with significantly higher yields for energy and basic material bonds that still reflect their fundamental credit uncertainties. Similar to 2015, year-to-date default activity has remained relatively confined to the commodity space.
NWM Bond was up +0.30% in April. The fund is a short duration investment grade bond fund that has benefited year-to-date (+1.7%) from narrowing investment-grade credit spreads. While the reflation theme moved government bond yields slightly higher for the month, credit spreads continuing to narrow has led to relatively solid performance for the bond fund. The Dex Short Universe Bond ETF returned -0.1% for the month while our credit oriented managers East Coast, RP Fixed Income Plus, and Marret returned 3.8%, 0%, and 1.4% respectively.
The stronger Canadian dollar detracted from global bonds, with NWM Global Bond down 1.8%.
The NWM mortgage pools continued to deliver consistent returns, with NWM Primary Mortgage and NWM Balanced Mortgage returning 0.2% and 0.4% respectively in April. 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 NWM Primary and 5.6% for NWM Balanced. If fully invested, the balanced fund’s current yield would be 5.9%. NWM Primary Mortgage currently has $7.6 million in cash and cash equivalents. NWM Balanced Mortgage has $24.2 million in; however, we have 12 loans that have been approved pending closing with a value of $29.7 million.
NWM Preferred Share was up 3.3% for the month while the BMO Laddered Preferred Share Index ETF was up 3.8%. Preferred shares started April with a bang, moving the first week up 4% before essentially flattening out for the remainder of the month. With strong returns for the month, April also marked the first time the preferred share market has had two consecutive months of positive performance since 2014. With reduced fears and negative interest rates, the 5-year Government of Canada yields increased from 0.68% to 0.88%, and credit spreads tightened forming the backdrop for a more stable preferred share market. The market flattened out later in the month as three large issues came to market, Brookfield Office Properties, Pembina Pipeline and TransCanada issued shares bringing an additional $950 million new supply to the market.
In Canada, the TSX was strong for the month at +3.7%. The story this year continues to be the rebound in commodities. The S&P/TSX Materials Index was +20% in April led by gold stocks while the S&P/TSX Energy Index was +5.9%. NWM Canadian Equity Income was +0.9% for April. The largest positive contributors to performance were Heroux-Devtek, Ag Growth, and Vermilion Energy. We sold Transforce and initiated a position in Hudson Bay Company where we like the potential to improve margins after new stores have been opened and to monetize their valuable real estate.
NWM Canadian Tactical High Income returned 1.05% during the month of April. Strong contributions came from stock specific names: WSP Global and Ag Growth. The fund under-performed the benchmark mainly due to its sector orientation being underweight in energy, healthcare and materials which were the 3 top performing sectors last month. New names added to the portfolio include Shaw Communications and Morneau Shepell while we sold Transforce.
In the U.S., both NWM U.S. Equity Income (+0.8%) and NWM U.S. Tactical High Income (+3.0%) had a good month from both a relative and absolute perspective. The recovery in financials/value names and health care stock selection (being long Pfizer and not owning Allergan) helped NWM U.S. Equity Income. Meanwhile, the advertising spending cycle improved, which ultimately helped CBS. During the month we initiated a position in Home Depot as housing continues to be a bright spot for the U.S. with repair/remodels showing good momentum.
For NWM U.S. Tactical High Income, strong results came from the fund’s overweight positions in energy, financials and material sectors. The float also helped contribute to performance as credit spreads tightened during the month. We added a new position called Synchrony Financial via put options and sold Oracle. It was a very busy month in terms of option writing, as the fund wrote 54 put options worth $47-million notional—one of the highest totals since inception.
NWM Global Equity was down 1.9% for the month of April which fared relatively better than the MSCI World Index (-2.1%). The U.S. dollar (USD) depreciated against the Canadian dollar which hurt the fund as it has approximately 55% USD exposure. Of our external managers, only Edgepoint was in positive territory (+0.5%) while the other managers detracted from returns; ValueInvest (-3.7%), Lazard Global Small Cap (3.1%), BMO Asia Growth & Income (-2.8%), and Pier 21 Carnegie (-2%).
Real estate increased in April with NWM Real Estate up 0.4%, with the iShares REIT ETF up 2.3%.
NWM Alternative Strategies was down 1.2% for the month (these are estimates and can’t be confirmed until later in the month). Of the Altegris feeder funds, Winton was down 5%, Brevan Howard -4.2%, Millenium -2.4%, and Citadel -2.0% as the USD currency translation created a drag of -3.4% for all USD funds. The Canadian-based funds had a solid month as RP Debt Opportunities was up 1.5%, Manulife GARS up 0.2%, while both Polar North Pole and RBC Multi-Strategy Alpha Fund were up 1.8%.
Precious metals had a fantastic month with NWM Precious Metals up 22.6% and bullion up 6.4%. The dovish tone of the Fed along with their perceived reluctance to raise rates and higher inflation all helped to move gold and gold stocks up.
April In Review
Usually, April showers bring May flowers but apparently Vancouver weather forecasters didn’t get the memo. With the hottest April on record, we enjoyed summer-like weather early. Unfortunately markets were not as hot as the weather and the near-term forecast remains cloudy with a chance of sun.
With the early-year panic firmly behind us, markets seem to have grudgingly moved higher globally and credit spreads narrowed as investors finished digesting the potential of a recession. It was merely a passing stomach ache and nothing more serious. Market volatility was destined to come after the hubris of past quarters.
It’s important to note that we believe that the global economy will be able to pull off a great escape and continue to improve on its anemic growth. We are living in a low-for-longer growth environment which entails a lower-for-longer return environment as well.
All ten bear markets since World War II have coincided with recessions and have led to declines greater than 30% for investors. When markets sell off and there isn’t a recession, generally the sell-offs are swift with almost an equally swift recovery period, making timing of short-term market movement extremely difficult. We do not believe we are headed for a recession; thus, sell-offs in the market will more than likely be followed by a recovery. We anticipate markets to be in a relatively ranged-bound environment for the foreseeable future.
Three headlines dominated the news during April. Oil continued its path back up and closed the month nearly at $46. The USD weakened to almost $1.25 Canadian and the Yen appreciated nearly 5.8% versus the USD. Good news for those of us who have travel plans to the U.S., bad news for those who are travelling to Japan.
Most of the movement in the market can be attributed to the inaction of both the Bank of Japan and the Fed. Both central banks took a “wait and see” approach as Japan wanted to further evaluate the impact from its decision to turn to negative interest rates while the Fed took a more laissez-faire approach to inflation showing more concern with global risk.
But there’s always risk. As Mark Twain once said, “October: This is one of the peculiarly dangerous months to speculate in stocks. The others are July, January, September, April, November, May, March, June, December, August and February.”
The most pervasive risk remains a Chinese hard landing. But sometimes the risk the capital markets least expects can be the most painful. That’s why the U.S. market drawdown was so significant in the first quarter. The strong dollar weighed on the U.S. economy the past couple quarters showing that they are not strong enough to carry the weight of the world on their shoulders along with a strong U.S. dollar. When you’re ranked number one by all economists, a little stumble can be quite painful as the only place to go is down.
More recently, China and Europe are showing signs of a stabilizing economy so some risk has abated; but there’s always risk. Britain potentially leaving the European Union in June and the U.S. election in November will definitely add more volatility to the markets later this year. But regardless of global risk, eventually the Fed will need to raise interest rates.
China’s growth rate came in at 6.7% for the first quarter. Although lower than last quarter’s 6.8%, the growth rate is still in line with their target of 6.5% to 7%. There have also been signs that the Chinese economy is stabilizing. Exports grew in March and car sales spiked 10%. Renewed infrastructure spending has also helped but has led to credit increasing sharply. These trends are not sustainable but recently have provided enough stability and potentially could lead to their economy growing faster than many people forecast.
Surprising most of the market, Japan kept the status quo on their easing program with deposit rates at -0.1% and asset purchases of 80 trillion Yen per year. Japan’s easing program continues to be massive, but the market was expecting more. By not expanding their program, the market has started to question the effectiveness of Japan’s policy (known as Abenomics).
The more recent strengthening of the Yen is caused by a myriad of factors that will continue to be a headwind for Japan. Deflation could lead to a stronger currency, so it makes sense that the Yen is stronger if the market is starting to question the impact of Abenomics.
Furthermore, a popular trade amongst global offshore investors has been to invest in the Japanese stock market while shorting the Yen. The thesis has been that Japan is similar to the U.S. in terms of an early-stage recovery. Quantitative easing is promoting investors to move further into risk assets and pumping up the stock market. Well, some of these investors are starting to exit their positions and the unwinding has only accelerated the rise of the Yen.
Europe grew by a seasonally adjusted 0.6% in Q1 this year, about double the pace of last quarter. Improving labour markets along with easy monetary policy have helped to fuel consumption. High debt levels and a banking system that is still trying to find stable footing are still concerns overall, but a solid start to the year for Europe.
After a weak first quarter we expect the U.S. economy to regain momentum thanks to a weaker U.S. dollar and higher oil prices. U.S. employment continues to be a pillar of the U.S. recovery. April non-farm payroll numbers showed only 160,000 new jobs and disappointed forecasts; however, 160,000 is still a great number as only 78,000 are needed to absorb new workers.
The rest of the economic numbers were a mixed bag for the U.S.. Personal spending remains soft, but there may be a rebound in consumption growth soon. In Canada, for every dollar received, Canadians spend more than $1; whereas our neighbors to the south are spending less than a dollar.
With healthy employment, low household debt and high consumer confidence all signs are pointing towards consumer spending picking up in the U.S.. Additionally, on the lending side, demand for consumer loans has picked up and banks have started to loosen standards on loans leading to an even rosier outlook. However, business investment continues to remain depressed.
Posing a mirror opposite to the consumer side, business loan demand is low and banks are tightening standards on business loans as well. When taken all together though, it’s only a matter of time before we have wage growth in the U.S. and when coupled with the potential of consumer spending picking up, a lower U.S. dollar and higher energy prices, U.S. growth should improve from its first quarter poor showing.
Much a Doha-bout Nothing
Some of the world’s largest oil producers met in Doha, Qatar mid-month to discuss a potential oil production freeze to cap the oversupply that has pressured oil prices. Talks fizzled even before they began as Iran made a last minute decision to not even attend the talks. With Saudi Arabia taking a firm stance of not freezing production unless other major producers did the same, the talks ended without any agreement.
Although oil fell by more than 6% after the announcement was made, it continued its climb upwards and ended the month at nearly $46. Although U.S. oil output fell for the 3rd consecutive month (from a peak of 9.595m to 9.022m), the fall has been more than offset by the increase in oil production from Iran. In fact, the Organization of the Petroleum Exporting Countries’ (OPEC) April production reached a new all-time high at 33.217m.
There are a myriad of factors that influence the price of oil making it nearly impossible to forecast. But it’s difficult to imagine oil roaring back to $100 levels. Even though the marginal buyer of oil is putting it in storage to sell at a later time, and at what they hope to be higher price. The higher oil goes, more oil production will come online increasing supply and eventually putting a cap on oil prices.
In what seemed to be straight out of a Tom Clancy novel, rumors abounded after this past February’s G20 meeting in Shanghai. Several media outlets reported the potential of a secret Shanghai currency accord struck during the meeting. In what recently has amounted to a currency war with a competitive devaluation of major currencies, the currency accord would effectively amount to a truce. War – what is it good for? Absolutely nothing! The casualties of the currency war have been mounting and manifesting through higher market volatility.
On the topic of foreign exchange markets, U.S. Treasurer Jack Lew noted “…we’ll keep each other informed and we’ll avoid surprising each other…. it is also important that all G-20 members honor their commitments to refrain from competitive devaluation, and to not target exchange rates for competitive purposes.” Lew also noted that he was leaving Shanghai with the risk of competitive devaluation greatly reduced.
An agreement between countries intervening in currency markets does have precedents. In 1985, France, West Germany, Japan, the U.K., and the U.S. struck an agreement to depreciate the USD versus the Yen and German Deutsche Mark. USD had appreciated strongly (sound familiar?) versus other global currencies and U.S. industries were suffering as a result. With Congress considering trade restrictions to support local industries, the Plaza Accord was struck in lieu of potential protectionist laws.
Whether or not an accord was struck is secondary to the market reaction. The tone of Lew’s comments suggest if anything there would be reticence to devaluation; if not a truce, then a cease fire in the currency wars.
No Canadian NHL team made it into the playoffs for the first time since 1970; not only that but Edmonton, Vancouver, Winnipeg and Calgary were the 4 worst teams in the Western Conference. We remind ourselves that there is a silver lining to every cloud and every Canadian team should have high draft picks for the coming year. However, with lowered expectations, Canadian teams could surprise on the onside next year. Much like this past quarter’s earnings season, expectations are key.
With the majority of earnings behind us for the quarter we can safely say, for the most part, things were better than expected. That being said, expectations were set very low. 3 months prior to the quarter, earnings forecasts were brought down over 9% with cuts in projections coming in every sector.
With the backdrop of a lowered bar, 77 % of companies were able to beat their earnings expectations while 57% of companies beat revenue expectations. On an absolute level, we still have earnings declining by 8.8% and revenue declining by 2.77%. This marks the third consecutive quarter of declining earnings and fifth consecutive quarter of declining revenue.
As expected, energy companies were the largest drag on the market but ex-energy, earnings only declined 2% and revenue actually grew by 1%. So there is a positive trend forming which hopefully will persist.
Unfortunately, a common narrative through the quarter has been of companies beating earnings expectations by cutting costs through massive layoffs. Halliburton laid off 6,000 people, Intel announced they would be cutting 12,000 jobs and Schlumberger cut an additional 11,000 employees bringing their total reductions to 20,000. Obviously cutting your workforce is not sustainable. Given that employment has been one constant beacon of light for the U.S. economy, hopefully the current trend of lay-offs does not expand and start to deteriorate overall employment numbers.
With Institute of Supply Management (ISM) numbers starting to improve and crude back in the mid-forties range, price re-inflation has dampened market temperament of an energy crisis contagion spreading into the rest of the market. Additionally, with a lower U.S. dollar, the earnings slowdown may just be temporary and may re-accelerate in the coming quarters.
Articles on a Canadian real estate crash have circulated for nearly 10 years now since the Great Financial Crisis but markets in Toronto and Vancouver continue to defy logic and any resemblance of sanity.
The PIRI 100 Index, which tracks residential real estate for 100 of the world’s key cities, has Vancouver at the top of its list this year for home price increases. Vancouver prices increased 24.5% for 2015 easily beating out Sydney at 14.8% and Shanghai at 14.1%.
In a goldilocks-type scenario, there is a trifurcation of markets with Vancouver and Toronto being too hot (growing at double digits), then cities impacted by weaker oil such as Edmonton, Saskatoon and Calgary have become too cold (dipping into negative year over year territory), and finally Montreal, Winnipeg, and Ottawa are just right, increasing at a sustainable rate of under 2%.
Canada’s budget deficit is expected to grow to $30 billion in 2016-2017. The country is spending to ensure the country’s future growth and prosperity. Considering the political instability in the U.S. with Trump gaining popularity and the potential for the United Kingdom to exit the European Union (labeled Brexit), the relatively more stable political landscape in Canada makes it more attractive to foreign investors.
Obviously, Vancouver real estate has resonated well with Chinese buyers. The diaspora impact has been largely felt across the lower mainland. Extremely volatile Chinese equity markets, coupled with a weak Canadian dollar, and stable Canadian government, have created the recipe to bring Vancouver home prices to the top of PIRI’s list.
Supply and demand dynamics continued to be skewed in a seller’s favour. National sales-to-new listings ratio is 61.7% while the ratio is 70% for Vancouver. A sales-to-new listings ratio between 40 and 60 percent is generally consistent with balanced housing market conditions, with readings below and above this range indicating buyers’ and sellers’ markets respectively. Furthermore, the number of months of inventory sits below 2 months in the Lower Mainland.
The increased demand and lower supply has led to a further increase of 6.97% in home prices in Vancouver in the first 3 months of 2016 alone.
Psychologically sellers are sticking to the last price and there is a lack of willingness to accept lower prices even when there are consistently higher and higher marks. In other words, if my neighbor sells his home for $2 million, as long as I have the flexibility, I am extremely reluctant to sell my home for less than $2 million. Eventually, the bubble could burst and prices could correct 30% or more as the sheer movement upward is unsustainable. But, with price momentum behind the markets, it is difficult to envision any major correction unless interest rates rise dramatically or flow from offshore investors dissipates.
CAD vs USD
At the start of the year, consensus was that western country ranking in terms of growth was the U.S., then Britain, and Continental Europe, followed by Canada. The exact opposite occurred with Canada growing about 3% in the first quarter compared to the U.S. at only 0.5%. The narrowing of growth divergence has had a significant impact on the Canadian / USD exchange rate.
Shorter term, currency trades on sentiment and flow; whereas longer term, currency levels are more influenced by the difference in real interest rates (interest rates net of inflation) between countries. All three have worked in Canada’s favour more recently, leading to CAD-USD to nearly go back to 80 cents. The resurgence in the Canadian dollar is largely attributable to oil rebounding. Oil hit lows of $26.21 on February 11 before rebounding to $45 at the end of April. According to Governor Poloz, every $10 rise in oil drives the Canadian dollar up by 2-3 cents.
The velocity of the Canadian dollar recovery took some by surprise but it only mirrored the depreciation we experienced at the end of 2015. Long USD, along with short commodity stocks and short emerging market equities have been popular trades among the investment community leading to crowding of all three trades and high risk as all three are correlated to each other.
Investors who were long USD in the derivatives market have closed out their positions; however, they are still not rushing in to increase their long CAD exposure so while they are no longer bullish on the U.S. dollar they are also not bullish on the Canadian dollar.
In terms of interest rate policy, the Fed dot plot shows the projection of all 16 Fed members on where they believe the Fed funds rate will be at the end of the year. This is still materially higher than the trajectory the market believes is in store for interest rate hikes. The Fed left the door open for the possibility of raising interest rates in June; however, that is an unlikely scenario given the enhanced political risk with “Brexit” also in June.
Now the markets price has a less than 50% chance of a rate hike in 2016, so there is not much more room to go lower. Positive news on the U.S. economy will likely lead to more hawkish commentary for the Fed if not a direct interest rate hike, reigniting strength in the U.S. dollar.
Although we believe eventually the USD will strengthen, timing of currency moves is notoriously difficult. We would advise against trying to time any such move. Instead we prefer to have one’s portfolio truly diversified with long term strategic exposure to U.S. assets and U.S. dollars.
At the beginning of April, the U.S. Treasury proposed new regulations to curb corporations from certain tax avoidance strategies. Pfizer and Allergan have borne the brunt of recent political criticism. Combined, the two health care companies have a market value of $300 billion which would make them the largest drug maker in the world. Such a merger was heavily criticized because economics of the merger relied heavily on tax benefits.
Tax inversion relies on two key components. First, a company domiciled in a low taxed country buys a company domiciled in a higher taxed country. Second, in what is commonly referred to as earnings stripping, the entity in the higher taxed country takes out a loan from its new parent company and is able to deduct interest payments from the loan, lowering its earnings and reducing taxes.
Tax inversion is not new, with the first inversion transaction occurring in 1982 with McDermott, but they have become more commonplace recently with several companies becoming serial acquirers.
The new rules come as the latest set of proposals from the Treasury, which mainly focus on a ban on serial inversions and earnings stripping. Both have a potentially large impact on future M&A activity as well as any multi-national companies. When inter-company debt is eventually refinanced the company will not be able to increase interest expense deductions in the U.S. or increase earnings in the lower tax jurisdiction meaning some multi-national companies will eventually be forced to pay more taxes.
There is a benefit to investors though. Serial acquirers often show blended earnings or pro-forma earnings where they include the original company along with the newly acquired company. There is often a large portion of discretion when reporting pro-forma earnings as it does not comply with any standardized rules.
By slowing down companies who constantly make acquisitions, these companies will eventually have one full year to report following regulated accounting practices (such as GAAP) as their situation normalizes providing investors more clarity on the details of the underlying businesses.
Negative Rates and the End Game
With a third of world policy rates effectively at or below 0%, the question is raised, who’s buying investments knowing they will have less money than they started with? An investment guaranteed to lose money doesn’t sound too appealing does it?
The concept of negative interest rates makes sense from the perspective of a struggling economy: discouraging savings, forcing banks to lend, depreciating currency, and increasing asset prices. But from the investor’s point of the view, the reasons are cloudier.
First, we have institutional domestic investors such as the Japanese Central Bank and large Japanese corporations who are forced to buy these bonds to match certain liabilities. Second, we have investors who think they can make money even with a negative yield drag. Higher than expected deflation or a stronger currency would help these investors earn a positive return. And finally, there are the doomsday investors. Government bonds generally provide better capital perseveration than equity markets. So if one expects a 40% loss in equities, they are happy tactically buying Japanese Government Bonds (JGB). Given that we do not believe one can time markets with any certainty and we are not constrained like Japanese corporations, we do not invest in negative interest bonds.
According to former IMF Economist Olivier Blanchard, “zero interest rates have disguised the underlying danger posed by Japan’s public debt, likely to reach 250pc of GDP this year and spiraling upwards on an unsustainable trajectory.”
At its current pace, by 2018 Japan will own 60% or more of JGB issues. Eventually, Japan will need to unwind its purchases. At that point, yields could skyrocket for Japan, leading to a difficult end-scenario for Japan as their extreme quantitative easing and negative rates may lead to further trouble down the road.
What did you think of April’s economic activity? Let us know in the comments below!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. NWM fund returns are quoted net of fund level fees and 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.