January In Review: a shake-up in the recent predictable markets

By Rob Edel, CFA

Highlights This Month

Read the monthly commentary in PDF format.

The Nicola Wealth Management Portfolio

Returns for the NWM Core Portfolio Fund were up 0.2% in the month of January.  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.

As mentioned earlier, the Canadian and U.S. yield curves shifted higher and steepened in January.  Canadian 2-year yields increased 0.15% versus a 0.25% increase in 10-year rates while 2-year yields in the U.S. increased 0.26% while versus a 0.30% increase in 10-year rates. For the month, the NWM Bond Fund was up 0.2% last month; an exceptional result given the increase in short-term Canadian yields.
NWM High Yield Bond Fund returned -0.3%, underperforming +0.7% for the Bank of America Merrill Lynch US High Yield Index due to the fund’s exposure to a weaker U.S. Dollar. The NWM High Yield Bond Fund continues to be very defensive with low correlation to the high yield index.

In fact, at the end of January, we have removed high yield beta even further by shifting 10% of Oaktree Global High Yield Bond Fund into the Apollo Credit Strategies Fund, which is a long/short credit investing hedge fund. We see the NWM High Yield Bond Fund performing well amid recent volatility. We also continue to be comfortable with U.S. Dollar exposure in the Fund, currently at 36%.

The stronger Canadian dollar negatively impacted the NWM Global Bond Fund, which was down 0.5% in January. The Canadian dollar appreciated 2.1% in January.

The mortgage pools continued to deliver consistent returns, with the NWM Primary Mortgage Fund and the NWM Balanced Mortgage Fund returning +0.3% and +0.4% respectively 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 4.4% for NWM  Primary Mortgage Fund and 5.3% for NWM Balanced Mortgage Fund.  NWM Primary Mortgage Fund ended the month with a cash of $7.0 million, or 4.2%.  NWM Balanced Mortgage Fund ended the month with $76.4 million in cash or 15.4%.

The NWM Preferred Share Fund returned 2.4% for the month, matching the BMO Laddered Preferred Share Index ETF. Preferred shares had strong returns to start the year as the Bank of Canada raised interest rates by 0.25% on January 17th and 5 year Government of Canada yields rose 0.21% to 2.08% supporting floaters and rate resets respectively.

Demand remains strong with $246 million new flow into ETFs. The support from flow can be seen in the new issuance market. There were five new issues brought to the market during the month totaling over $1.3 billion. Given strong compression in reset spreads for new issues, we only saw value in one of the preferred shares.  Despite what we view as expensive pricing relative to outstanding preferred shares, investors were eager to absorb the new supply as all of them were oversubscribed.

Canadian Equities were weaker in January, with S&P/TSX -1.4% (total return, including dividends).  The NWM Canadian Equity Income Fund returned -1.2% in January.  Strong consumer discretionary and lumber sector performance, along with prudent stock selection in the energy sector helped returns during the year.

We added West Fraser Timber to the portfolio and sold Canadian Tire. Top contributors to performance were Medical Facilities, Dollarama, and Aritzia. Detractors were Heroux, Element and CNQ. The NWM Canadian Tactical High Income Fund returned -0.8% in January which was a decent performance given nine out of eleven S&P/TSX sectors were in negative territory.

Market volatility increased during the month which provided the Fund an opportunity to add three new names to the portfolio that had sold off (Gluskin Sheff, Empire Company & Canadian Western Bank).  The Fund’s current delta adjusted equity exposure is ~44% and has been moving up as the market has been going down.

Foreign Equities were stronger last month with the NWM Global Equity Fund returned 2.5% vs 3.99% for the MSCI ACWI (all in CDN$). The Fund underperformed the benchmark mainly due to being overweight consumer staples and underweight the top performing sectors (i.e. Info Tech and Financials).

Performance of our managers in descending order:  C Worldwide +4.7% (~23.6% in financials and ~23.1% in Info-Tech helped propel stronger than benchmark returns); Edgepoint +4.31%, NWM EAFE Quant +3.13%  (underweight staples & overweight financials added to performance).  Lazard +1.64% (outperformed MSCI World Small Cap Index by 28bps). BMO Asian Growth & Income +0.87%.  ValueInvest +0.05 (~49.5% in consumer staples which was among the worst performing sectors in January)

The NWM U.S. Equity Income Fund increased +6.1% in U.S. dollar terms in January versus a 5.7% increase in the S&P 500 (all in U.S. dollar terms).  No new names were added; within Defense, we sold out of Raytheon and added to L3 Technologies.  While we continue to like the defense space, our higher conviction in L3 Technologies led us to consolidate our positions (we also own Boeing).

We added to our positions in software companies Microsoft and Adobe on greater conviction in corporate spending, specifically software.  Most of the positive absolute performance came during the first few weeks of the month, with the positive relative performance occurring in the last week when the markets traded flat/slightly down.  Our defensive positions contributed to our relative performance during the last week of January: gains in hospital HCA and medical device companies, as well as tower company Crown Castle, more than offset softness in our positions in aggregates company Vulcan Materials and money manager Blackrock, and not owning Amazon.

The NWM U.S. Tactical High Income Fund’s performance was flat during the month versus a 5.7% increase in the S&P 500 (all in U.S. dollar terms). The Fund’s extremely low equity-equivalent exposure (~15.5% beginning of the month) and poor performance in L Brands & Dave & Buster’s hurt the Fund’s performance. Hormel Foods and Delphi were two new names added during the month. The good news is that volatility is on the rise with the VIX increasing ~38% which is providing the Fund with higher option premiums for high-quality names we want to own.

In real estate, the NWM Real Estate Fund was down 1.1% in January versus a flat return for the iShares REIT Index. We report our internal hard asset real estate Limited Partnerships in this report with a one month lag.  As of January 31, December performance for SPIRE Real Estate LP was +0.5%, SPIRE U.S. LP +1.4% (in US$’s), and SPIRE Value Add LP +0.4%.  Year to date returns for SPIRE Real Estate LP were +10.6%, SPIRE U.S. LP +9.7% (in US$’s), and SPIRE Value Add LP +19.4%.

The NWM Alternative Strategy Fund was up +1.0% in January (these are estimates and can’t be confirmed until later in the month) with Winton +2.9%, and Millennium was unchanged.  Of our other alternative managers, RP Debt Opportunities was +0.7%, Polar North Pole Multi-Strategy +0.5%, and RBC Multi-Strategy Trust +1.8%.  Winton and Millennium are based in U.S. dollars so were negatively impacted by the strong Canadian dollar last month. Precious metals stocks were weaker last month with the NWM Precious Metals Fund -3.6% while gold bullion gained 2.1% in Canadian dollar terms.

January In Review

The year has got off to a fast start with most global equity markets continuing to move higher through January.  Even with healthy economic growth and strong corporate earnings, the pace of the market advance looked unsustainable with a number of developing inconsistencies.  Stocks were moving higher, bond prices were falling (yields moving higher), and the U.S. dollar was weakening.

And what’s with Canadian stocks?  The S&P/TSX was one of only a handful of global exchanges to be in the red last month, down 1.4% versus a 5.7% increase in the S&P 500 (+4.0% in Canadian dollar terms), the strongest January advance for the U.S. big cap index since 1997.  All this has been good for President Trump and his “America first” platform, but perhaps not for long, as markets broke sharply to the downside in early February.  We’ll take a closer look at all these issues this month, and try to determine their implications for the rest of the year.

While U.S. equity markets peaked on January 26th and ended the month on a weak note, for most of the month, fear of missing out was driving investors into equities. According to a weekly survey conducted by the American Association of Individual Investors, bullish sentiment continued to build during the month drawing retail investors into the market.  Discount brokerage firms Charles Schwab, E*Trade, and TD Ameritrade all reported a surge in new account openings last quarter with more investors now believing the market won’t peak until at least next year.

Given the strong run for stocks in 2017, market commentators have been wary of the strong start to the year.  Merrill Lynch’s Michael Hartnett called the market “super-frothy” and commented mid-month return’s for the S&P 500’s would result in an annualized return of 133% if the current pace were maintained.

During the fourth months previous to January 17th, a net $58 billion was committed to global mutual funds and exchange-traded funds, the biggest four-month inflow since records began in 2002, and average cash balances for Merrill Lynch’s portfolio managers fell to five-year lows of only 4.4%. With a third of the stocks in the S&P 500 trading at 52-week highs, according to MKM Partners, the market’s rally appeared strong and broad.  Any sign of weakness was treated as a false alarm as the herd continued to push the market higher.

For President Trump, it has been a welcome boost to what has been a tumultuous first year in office.  Other than tax reform, the Donald has had few victories to help refute the claim sinking poll numbers are unjustified.  Along with rising business and consumer confidence, the President has been able to point to the stock market rally as hard evidence that the economy and “Trumponomics” are working.

According to a recent Wall Street Journal survey, most economists actually agree Trump deserves at least some credit for the economy’s recent strength and his action on taxes and regulation have created a more pro-growth environment.  Investors, whether they know it or not, agree.

Despite Trump’s America First rhetoric, the rally hasn’t been confined to just U.S. stocks.  Emerging market equities, particularly China, as well as Japan, and Europe, have also been strong.

In 2017, foreign stocks actually outperformed U.S equities, as investors started to rebalance portfolios.  According to EPFR Global, $20 billion has been redeemed from U.S. equity funds since the beginning of 2017 while $42 billion has been allocated to continental Europe and $55 billion to Japan.  According to Capital Economics, net inflows into emerging market securities (stocks and bonds) hit an all-time high last year.

It’s certainly not economic growth or corporate earnings that have driven investors overseas.  With about half of S&P 500 companies having reported fourth-quarter earnings, roughly 80% have beaten earnings and revenue estimates, which according to Factset is the highest percentage since they started tracking this metric in Q3 2008.  Based on present trends, the S&P 500 is on track to grow fourth-quarter revenue 7.5% and earnings 13% year-over-year.

For their part, Wall Street analysts have been remarkably bullish with their estimates leading into reporting season, making the smallest cut to their quarterly bottom-up S&P 500 earnings forecast since 2010.  No, the reason investors were shifting into foreign stocks was not that prospects in the U.S. looked worse; it’s that the rest of the world looks better, and in the case of stocks, cheaper.



Even before Mnuchin’s attempt to trash the greenback, traders had started shorting the dollar, despite the increased interest rate spread between U.S. 10-year yields and those of other developed government bonds, like German Bunds.  Surprisingly, a tightening Federal Reserve hasn’t necessarily translated into a stronger dollar historically as interest rate differentials are not the only factor influencing currency rates.

As mentioned above, the relative attractiveness of foreign equities versus U.S. equities has worked against the dollar as investors have shifted capital abroad, as have the prospects of other central banks following the Fed’s lead in tightening monetary policy.  Synchronized global growth is a tide that lifts all boats, and the U.S. boat has already been rising for several years.

The Canadian dollar was also stronger last month, gaining just over 2%, but Canadian stocks were down.  Like Europe, Japan and Emerging markets, the Canadian economy also appears to be performing better than expected, adding 420,000 jobs last year and growing GDP an estimated 3%, highest amongst G7 economies.

Like the Federal Reserve, the Bank of Canada is also one of the only central banks to be actually raising short-term interest rates, as it did once again in January with the C.D. Howe Institute forecasting two more rate hikes in 2018.

So why are Canadian stocks not feeling the love?  Concerns over NAFTA, high consumer debt levels, and tighter mortgage lending rules were likely weighing on investor’s minds, but the composition of the Canadian stock market is probably most to blame.

The technology and healthcare sectors have been leading the S&P 500 higher, but the S&P/TSX doesn’t have much representation in either sector.  These two sectors have a combined 38% weight in the S&P 500 but make up a mere 4.5% of the Canadian S&P/TSX.  What the Canadian index has is a large weight in energy, which should have performed well, given oil continued to rebound last month.  Unfortunately, Western Canadian Select, the type of oil produced from the oil sands, did not rally as much as WTI crude and sells at a substantial discount.

Another likely factor favoring U.S. stocks is tax reform.  Lower U.S. corporate tax rates have helped push up corporate earnings estimates for U.S. companies helping lead American stock prices higher.  Most Canadian companies have received no such tax relief.  Quite the opposite actually.  And a minimum wage hike in Ontario is an additional headwind for corporate earnings. Canada should benefit from a stronger U.S. economy and the performance gap between Canadian and U.S. stocks should narrow over time, but don’t expect any quick fixes.  Perhaps in a downturn Canadian stocks would fall less?

A strong dollar is typically a sign of a strong economy, however as Treasury Secretary Mnuchin points out, a weak currency helps trade, and thus economic growth, in the short term.  While the fall in the greenback may be good for the U.S. economy and stocks, higher bond yields are not.  Short-term rates have been moving steadily higher over the past few months, heavily influenced by Fed tightening, but longer-term yields have lagged, mainly due to below trend inflation.

Last month, however, 10-year yields outpaced their shorter-term rivals by increasing 30 basis points to 2.70% versus a 25 basis point increase in the 2-year yields.  The move up in the 10-year was significant in that it broke through what many strategists believed to be key technical levels for bonds.  According to DoubleLine’s Jeffrey Grundlach, a move beyond 2.63% would signal an end to the bond bull market, while old-time bond guru Bill Gross highlighted 2.65% as a key resistance level.  10-year yields blew past both but stocks kept moving higher.  Price volatility increased, but stock prices and valuations remained strong.

Both supply and demand factors can be used to explain why rates moved higher.  From a supply perspective, higher projected budget deficits, partly as a result of last month’s tax cuts, and a shrinking Federal Reserve balance sheet will increase the dollar amount of government bonds in circulation, thus leading many traders to anticipate falling bond prices and higher yields.  Corporations repatriating funds from foreign subsidiaries could also add to bond supply.  Even though these balances were deemed to be offshore for tax purposes, most U.S. companies invested the cash in U.S. denominated bonds and would now be in a position to sell them in order to either buy back stock or invest back into their businesses.

On the demand side, as with the U.S. dollar, stronger global growth reduces the relative attractiveness of U.S. bonds given the prospect of the ECB and the Bank of Japan eventually ending their bond-buying programs.  Another factor potentially weighing on demand is inflation.  Investors don’t like holding longer-term bonds if they believe inflation is going to increase.

The fact 30-year bond yields have risen less than 10-year yields, and 10-year yields increased less than 2-year yields indicates investors weren’t convinced inflation would rise much in the future.  2-year bonds are generally influenced more by what the Federal Reserve is doing with monetary policy while longer-term bonds are impacted more by inflationary expectations.

With longer-term yields rising more than shorter-term bond yields last month, inflation fears appear to have marginally increased in January, however, the fact 10- and 30-year breakeven inflation rates are still below early 2017 levels indicates investors expect inflation to remain generally contained.


Knowing why bonds were moving higher is important in determining how it impacts stocks.  Historically, stocks and bond prices generally move in different directions, which is why a diversified portfolio containing both typically provides better risk-adjusted returns.  During a normal economic cycle, stocks tend to do well as the economy expands and earnings growth improves.  Bonds underperform during the expansion period as interest rates move gradually higher, but it is only later in the cycle when inflation starts to kick in that bonds come under real pressure.

Earlier in the cycle, it’s modestly higher real interest rates that provide a headwind for bond prices, which in a normal market should be more than offset by bond coupon yields.

Eventually, inflation and higher nominal interest rates choke economic growth and pressure corporate earnings causing investors to flee equities for the safety of bonds.  The resulting demand for fixed income drives yields lower and sets the stage for another cycle.

This relationship worked well during the 1980’s and most of the 1990’s when there actually was inflation but has fallen apart the past 15 years or so as new large buyers of U.S. government bonds entered the scene.  As a result of running massive trade surpluses, China accumulated a large foreign currency reserve and invested a large part of it in U.S dollars.  Other big buyers included OPEC producers, who were also running massive trade surpluses, and the Federal Reserve themselves, who bought bonds during the financial crisis.

During this time period, interest rates have tended to move in just one direction, namely down, regardless of what the economy or the stock market was doing (though the stock market has mainly been going up).  Because of this, it has become the norm for stocks prices and bond yields to move in the same direction.  During the financial crisis, lower yields (high prices) were actually taken as a sign of crisis for markets and the economy, while higher yields were viewed positively and indicated the economy was out of danger.  So what does the stock/bond price relationship look like now, and more importantly, what is the current move in bonds telling us about where we are in the economic cycle?

Last month, we saw both the old and new stock/bond relationships.  Up until the market peaked on January 26th, stocks and bonds were both moving in the same direction (higher) like they have for the past 15 years or so.  Yields were moving higher, but mainly because the economy was stronger and expectations the Federal Reserve would be able to slowly raise short-term rates, not because of inflation that would eventually usher in a recession and the end of the business cycle.

On January 26th, however, yields continued to move higher, but stocks started to retreat, in line with the old more normal stock/bond relationship.  Apparently, enough was enough for equity investors.  At some point, it was inevitable that higher yields would start impacting equity valuations.  At the very least, stock dividends were beginning to lose their luster when compared to higher bonds yields.

Then on Friday, February 2nd, U.S. employment data was released showing stronger wage growth, and the markets began to discount higher inflation and the eventual end of the economic cycle.  Yields still went up, but now it was inflation risk or term premium, that was moving rates higher.  Predictably, the stocks sold off hard, with the S&P 500 falling just over 2%.  Fast forward to Monday and give the market the weekend to brood over this new potentially inflationary environment, and the S&P 500 proceeded to fall an additional 4%, or just over 7% from its peak on January 26th. Yields fell as well, but the damage had been done.  Or had it?

If inflation is indeed accelerating and the Federal Reserve is behind the curve and needs to raise rates more aggressively, a recession is likely just around the corner and stocks will probably fall even further as they start to discount the slowdown.  Longer-term yields will also fall and the yield curve will flatten and then invert as investors seek the safety of bonds; in other words, a normal cycle.

While we see this as the likely future roadmap for the market, we think it’s a bit premature to be planning the trip quite yet. Yes, wage growth at 2.9% recorded its strongest gain since June 2009, but this was only marginally higher than July 2016’s 2.8% increase.

Also, most of the growth came from a 5% increase in supervisor and non-production worker wages.  Non-supervisory workers, who comprise 80% of the workforce, saw their wages increase only 2.4%.  Overall personal income growth is still below that of past recoveries, and even if the U.S. has reached full employment and wage inflation picks up, it’s not a given inflation will immediately move higher.

The historical relationship between PCE (Personal Consumption Index) and average hourly earnings has been far from perfect.  Longer-term inflationary expectations still remain below historical levels and show little signs of breaking out to the upside.

We also believe the market had a little help during its dramatic correction in late January/early February. A popular investment strategy has been to short volatility, typically through one of several exchange-traded notes that would sell CBOE Volatility Index (VIX) futures.  Once the market started to sell off, volatility moved higher causing mass short covering and a vicious feedback loop resulting in a spike in the VIX.  Holders of these Exchange Traded Notes (ETN) were virtually wiped out.

The last couple of months we have written about Bitcoin and marijuana stocks, warning about perils of investing in these momentum-driven investment strategies.  We totally missed these short volatility ETN’s.  We hope readers did as well.  The rise in volatility not only helped spook the market, but it created selling pressure from so-called “risk parity funds” that use leverage to allocate to asset classes based on predetermined risk levels.  Higher equity volatility meant the asset class now had a higher risk level in portfolios, which needed to be brought back into line by selling equities.  BMO’s Mark Steele estimates that while about $8 billion was held in low volatility ETN’s, about $1 trillion is managed by risk parity managers across multiple asset classes.

A paper written by Vineer Bhansali and Lawrence Harris in November estimated the total assets under management in volatility-contingent strategies, which includes risk parity, volatility targeting funds, risk premium harvesting and trend followers, is about $1.5 trillion.  If volatility remains elevated, all will likely be selling, thus putting additional downward pressure on the market.

It had been a good run.  The S&P 500 had gone more than 400 trading days without a 5% drawdown (amount of decline from a market peak to trough) and hadn’t fallen three days in a row since early December. If not for a slight gain on January 31st, the S&P 500 would have recorded 6 consecutive trading days in the red after hitting an all-time high on January 26th, and by the time the dust had settled on February 5th, had suffered a cumulative drawdown of just over 7%, and counting.  More on this next month.

Markets could continue to sell off, especially if risk parity and other quantitatively-oriented funds have more selling to do, but we don’t see the signs of a sustained downturn. The global economy is too strong and forecasts are rising, not falling.  We expect inflation to increase, but don’t see the economy overheating, at least not yet.

It wasn’t that long ago that investors were worried that there wasn’t any inflation, now they’re worried that there is too much?  The lack of volatility in the market was also a concern, as was the duration of the market rally and the absence of a pullback of any kind.  Investors were getting complacent and the market overbought  Problem solved.  Maybe now we will have a more normal market, one that goes up, and down.



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.