September In Review: Typical Low Volatility, But For How Long?


By Rob Edel, CFA

Highlights This Month


Read this month’s commentary in PDF format.

The NWM Portfolio

Returns for the NWM Core Portfolio Fund were up 1.2% for the month of September.  This Core Fund 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.

The Canadian yield curve endured a parallel shift higher last month, with both 2-year and 10-year Canada yields increasing 0.24%.  U.S. yields followed a similar pattern, with 2-year treasuries increasing 0.15% and 10-year treasuries +0.22%.  For the month, the NWM Bond Fund was up 0.3%, which is a good result given the move up in yields.  A portion of this increase is likely due to performance earned in August and reported in last month’s results.

NWM High Yield Bond Fund returned +0.6% in September, compared to +0.9% for the Bank of America Merrill Lynch U.S. High Yield Index. High yield bond prices continue to be supported by positive technical factors, including new inflows and coupon reinvestment needs, combined with low levels of high yield supply. Fundamentally, there is little imminent prospect of a U.S. economic recession and the expected high yield default rate is low at 2%. However, high bond prices, interest rates, and credit spreads remain historically low, thus limiting the upside in this potentially volatile asset class. As such, the NWM High Yield Bond Fund remains defensive as it has been all year, while still earning a 3.5% yield.

Global bond returns were strong again last month, with the NWM Global Bond Fund returning 0.3%.

The NWM 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.  Current yields are 4.4% for the NWM Primary Mortgage Fund and 5.3% for the NWM Balanced Mortgage Fund.  The Primary fund ended the month with cash of $6.4 million, or 3.8%.  The Balanced fund ended the month with $37.0 million in cash or 7.5%.

The NWM Preferred Share Fund returned 2.3% for the month of September while the BMO Laddered Preferred Share Index ETF returned 1.7%.  The market rose as the Bank of Canada raised interest rates by 0.25% after increasing rates in July. 5-year Bank of Canada yields closed the month higher at 1.75% and credit spreads narrowed. National Bank announced they would be redeeming their Series 28 shares surprising the market and causing bids to be placed on other banks’ preferred shares that are not convertible into equity.

Regulations mean that these securities slowly become more and more expensive debt instruments for banks. We have been concerned with new bank issuance coming to market at an accelerated pace; however, bank issuance has been muted. Scotiabank is currently marketing a hybrid security that may provide an alternative source of capital for banks and may lead to less preferred share issuance in the future. Reducing supply in the market may cause prices to move higher.

Canadian equities were stronger in September, with S&P/TSX +3.1% (total return, including dividends).  The NWM Canadian Equity Income Fund matched the index with a +3.1% return, while the NWM Canadian Tactical High Income Fund was +1.1%.

The NWM Canadian Equity Income Fund benefited from favourable returns in select consumer discretionary names and no exposure to the gold sector.  Alternately, the fund’s underweighting in energy hurt relative returns.   NWM Canadian Equity Income Fund exited positions in West Fraser Timber, Canfor, and Prairie Sky while establishing new positions in Winpak and Arc Resources.

In the NWM Canadian Tactical High Income Fund, the underweight in energy hurt the fund’s relative performance.   The fund still maintains a low net equity exposure (current delta adjusted exposure is 36%).

Foreign equities were also higher last month, with the NWM Global Equity Fund up 1.8% compared to a 1.9% increase in the MSCI All World Index and a 1.7% increase in the S&P 500 (all in Canadian dollar terms).  Results for our external managers were mainly higher last month, with Lazard Global +5.3%, Edgepoint +3.0%, Pier 21 Carnegie +1.5%, and Pier 21 Value Invest +0.9%.  BMO Asia Growth & Income was the only manager with negative returns, returning -1.5%.   Our new internal Europe Australasia & Far East (EAFE) quantitative investments returned an index-like +2.3%.

NWM U.S. Equity Income Fund increased 2.3% in U.S. dollar terms and the NWM U.S. Tactical High Income Fund increased 1.5% versus a 2.1% increase in the S&P 500 (all in U.S. dollar terms).  In the NWM U.S. Equity Income Fund, we sold our position in Becton Dickinson and reallocated the proceeds to existing med-tech holdings Medtronic, Boston Scientific, and Zimmer.  As for the NWM U.S. Tactical High Income Fund, we were called away on our ServiceMaster and Tractor Supply positions.  The net equity exposure (delta) in the NWM U.S. Tactical High Income Fund is down to a very defensive 20%.

In real estate, the NWM Real Estate Fund was up 0.1%, matching the iShares REIT Index.  Our internal hard asset real estate limited partnerships are priced with a one month lag.  August performance for SPIRE Real Estate LP was +1.0%, SPIRE U.S. LP +1.0% (in USD), and SPIRE Value Add LP +5.3%.

The NWM Alternative Strategies Fund was up +0.1% in September (these are estimates and cannot be confirmed until later in the month) with Winton -2.0%, Citadel -0.2%, Millenium +0.1%, and Brevan Howard -1.0.  We have now completed our redemptions of Brevan Howard.  We have also learned Citadel will be returning money to the Altegris feeder fund we invested in, so this position will be wound down over the next few months.  Of our other alternative managers, all have had positive performance with RP Debt Opportunities +0.8%, Polar North Pole Multi-Strategy +1.0% and RBC Multi-Strategy Trust +1.5%.

Precious metals stocks were weaker last month with the NWM Precious Metals Fund -2.8% with gold bullion -3.2% in Canadian dollar terms.

September In Review

Historically, September is one of the weakest months of the year for U.S. stock returns.  According to the Stock Trader’s Almanac, the S&P 500 has averaged -0.5% each September since 1950 while the Dow Jones Industrial Average has lost 1.1%.  There are theories on why traders seem so gloomy each September, but the “September Effect” largely remains an unexplained market anomaly.  It’s certainly not a trend or strategy we would invest in.

Case in point, this past September investors were rewarded quite handsomely, with the S&P/TSX up 3.1% and the S&P 500 +1.7% (both in Canadian dollar terms).  The S&P 500, in fact, has been moving consistently higher all year, which is perhaps a mitigating fact in negating the historical September effect.

LPL Financial’s Ryan Detrick recently noted that the S&P 500 entered September trading 4% above its 200-day moving average.  Of the past 14 Septembers where the S&P 500 started the month trading above its 200-day moving average, it has gone on to post positive returns nine times.  After this month, make it ten out of fifteen.  As has been the case all year, markets lacked volatility of any kind, with the Wall Street Journal reporting the trading range for the month hitting its lowest level in 66 years.

Over the past five years, the S&P 500 has experienced a daily 2% correction on 19 occasions, but none of them have occurred this year.  In fact, for the first time since 2005, the market has not moved either up or down more than 2% and has only experienced moves of 1% or more on eight occasions.  Not since 1972 has the S&P 500 experienced so few big moves.  Positive returns and low volatility, what else could investors want?

Well, more of the same of course. In order for this to happen, however, factors driving the market higher last month need to be sustainable.  We believe the prospect of higher inflation or more specifically reflation, and the potential for U.S. tax reform (also known as the Trump Trade) were largely responsible for last month’s strong returns.

Certainly, bond yields hit a positive inflection point after the U.S. government debt ceiling was successfully extended last month, rejuvenating investor hopes around some kind of U.S. corporate tax cut being enacted.  Lower taxes would be good for economic growth and good for corporate earnings.

Hopes that inflation might start to move higher was also evident last month.  Both stocks and bond yields moved higher, but more importantly, the yield curve started to steepen.  2-year U.S. government bond yields have been rising for most of the year in anticipation of the Federal Reserve raising short-term interest rates.  10-year government bond yields have not followed suit, and if anything, have been falling.  As a result, the yield curve has flattened, hardly a sign of reflation and stronger economic growth.

Central banks have a lot of influence on short-term rates, but longer-term yields are determined by the market and traders’ expectations on future inflation rates.  A steeper yield curve is indicative of higher inflationary expectations.  We are not going to talk about tax reform this month.  Not because we don’t believe it is important, but because it is an evolving and complex issue.  We suspect it will still be topical next month so we will revisit it in more detail then.

Inflation, however, is a subject we feel deserves more immediate attention as it will be key in determining whether the positive returns we saw last month will be sustainable.

As we mentioned last month, inflation and economic growth typically follow a reasonably predictable cycle.  We say typically because not every cycle is exactly the same, and the severity of the financial crisis has certainly altered the normal course of the present cycle.

In a recession, inflation peaks and starts to decline as demand falls off.  In response, central banks cut interest rates in order to stimulate growth, which is positive for bond returns (lower yields mean higher bond prices).

As the economy starts to recover, inflation, being a lagging indicator, continues to fall but economic growth and corporate earnings start to recover.  This is a very attractive environment for stocks, with lower interest rates and recovering demand.  As the recovery takes hold and inflation starts to move higher, central banks begin to tighten monetary policy and interest rates start to move higher.

In the final stage of the cycle, inflation continues to increase, but higher interest rates start to negatively impact demand, driving economic growth lower.  In this part of the cycle, nothing does well, except maybe cash and gold.

As an investor, knowing where you are in the cycle, especially as we approach the final “stagflation” stage, is crucial to successful tactical asset allocation.  It is also vital for central banks and monetary policy.  If we are still in the “recovery” stage of the cycle and the Federal Reserve tightens prematurely before growth is sustainable, the Fed risks tipping the economy back into recession.

On the other hand, if the economy moves well into the “overheat” stage and the Fed delays raising interest rates, inflation could accelerate more such that the Federal Reserve falls behind the curve and needs to raise interest rates more aggressively. Again, this would drive the economy into recession.

As highlighted above, recessions usually go hand in hand with bear markets, and while there are other events forecasters worry about, a mistake by the Fed of tightening either too soon or too late, typically tops the list of many forecasters’ concerns.  In line with this, a flattening yield curve is a negative sign as it indicates the market believes future interest rates are going to fall, likely due to the central bank projecting wrong timing, and a recession is soon to follow.

So how does the Fed determine where the economy is in the cycle?  One of their go-to indicators is the Phillips Curve.  Named after New Zealand economist William Phillips, the Phillips Curve describes the historical inverse relationship between the unemployment rate and inflation.  When unemployment is high, wage growth and inflation should be low.

Theoretically, there should be an equilibrium level of unemployment where employment and wage growth are applying neither an inflationary or deflationary influence on the economy.  Called the non-accelerating inflation rate of unemployment (NAIRU), the natural rate of unemployment, or simply full employment, the Federal Reserve estimates this level to be around 4.6% presently.  The conundrum facing the Fed is that with an unemployment rate of 4.2%, below what they believe is NAIRU, inflation was only 1.4% last month, well below their 2% target level.

Historically, whenever the unemployment rate has fallen below the natural unemployment rate, a recession soon follows, but this is because inflation has typically been increasing, which in the recent cycle it has not.

Wage growth, which was a stronger 2.9% in September, otherwise has been stuck around 2.0 to 2.5% for most of the year and is still well below the 4% level typically associated with past recessions.

Does low wage growth and stagnant inflation rate mean the economy is still too weak for the Fed to be raising rates?  Is there something wrong with the Phillips Curve and the historical relationship between unemployment and inflation?  These are important questions because the “prize” for getting them wrong is likely a recession and a bear market.

So what is going on with inflation?  There of lots of theories, which we will do our best to review, but like with everything in economics, there are no firm conclusions.

Janet Yellen, Chairwoman of the Federal Reserve, believes the current weakness in Consumer Price Index (CPI) is “transitory.”  She believes short-term declines in things like the cell phone plans, prescriptions drugs, and online purchases have temporarily depressed the rate of inflation.  She generally believes the Phillips Curve relationship is intact and prices should start to move higher soon.

Bank Credit Analyst’s Peter Berezin largely agrees but has a slightly different take on the Phillips Curve.  Rather than being linear, Berezin believes the Phillips Curve is kinked such that when unemployment is above 4% or 5%, changes in job growth don’t really impact wage growth.  It’s low no matter what.  Only when the unemployment rate gets below 4% or so, the inverse relationship between inflation and the unemployment rate is really strong.

Others fear low inflation itself is keeping prices from rising.  Because inflation has been low for so long, consumers have come to expect low inflation.  This is especially worrisome to central bankers because once deflationary expectations become ingrained into the consumer’s psyche, it is incredibly hard to shake.

Another explanation for the breakdown in the Phillips Curve relationship could be more slack in the labour force than the current 4.2% unemployment is indicating.  If one were to add back all workers who are marginally attached and those working part-time for economic reasons, the unemployment rate jumps up to 8.3%.

Also, the official unemployment rate only tracks workers who are actively still looking for work.  Given generous disability programs, many displaced workers may have opted to drop out of the workforce but could be lured back if the right opportunity presents itself.

Demographer Nicolas Eberstadt believes the labour participation rate for men 25 to 54 years old is lower now than during the Great Depression, with a fifth of prime working age men on Medicaid.  The Census Bureau pegs the non-working male participation rate in federal disability programs at 60%.  Some of these workers are legitimately disabled, but some might be skirting the rules, especially since their income on disability may be only marginally lower than when they were working.

The composition of the job market might also be a factor.  During the recession, wage growth did not decline significantly because many of the jobs lost were lower skilled and lower paying.  During the recovery, the reverse has occurred, with lower paid workers being rehired, particularly in industries like retail and hospitality.

Researchers at the San Francisco Federal Reserve also believe demographics are also playing a role in keeping wage growth low.  As high-paid baby boomers retire, they are being replaced with younger and cheaper workers.  While total wage growth may be disappointing for continuously employed workers, wages have increased more rapidly over the past few years.

Going forward, the impact of all these factors should start to become less pronounced such that average wage growth should start to increase and Fed Chairwoman Yellen’s belief in the transitory nature of the recent soft patch in inflation vindicated.

Even Janet Yellen, however, is willing to concede there may be some more structural issues impacting the economy and keeping prices low.  Wage growth typically tracts productivity growth; the more productive a labour force is, the higher their wages can grow.  Given productivity growth has been so slow, it is not unexpected that wage growth has stalled.  Even worse, labour’s share of corporate income has fallen, likely due to a loss of bargaining power and lower union membership.

Globalization is also likely to blame, with low priced imports from China driving domestic inflation lower, as is technology and automation.  Lower prices are not a just a byproduct of the last recession, it’s a trend that has been in place since the 1982 recession.  Core inflation has been consistently moving lower with each subsequent recession.  Despite the recovery in demand, companies don’t feel they have pricing power.

In a global economy that is constantly being disrupted by new technology and companies like Amazon who are willing to trade off profit margins for market share gain, it’s no wonder most businesses believe prices are more likely to go down than up.

The unpredictable nature of inflation leaves the Federal Reserve in a tough spot.  The Fed will likely increase short-term rates once more in December and has targeted another three raises next year.  At the same time, the Fed’s longer-term forecast for the Fed Funds Rate has been consistently falling and now sits at just 2.75% as less Federal Open Market Committee (FOMC) members are seeing upside risks to inflation and growth.  Federal Reserve governors are far from unanimous on how quickly they should tighten monetary policy.

Also uncertain is who will actually be running the Federal Reserve next year.  Chairwoman Janet Yellen’s term is up in February, and while President Trump has indicated he may ask Yellen to serve another term, a number of other candidates have also been mentioned.

The Chairperson has a lot of influence over the direction of monetary policy so the Donald’s ultimate choice could have a major impact on the economy and markets going forward, regardless of what inflation does.   The Fed has a lot of balls to juggle, and we don’t even know who the juggler will be next year.

Last month we highlighted some potential issues that could arise during or after the next recession.  We referred to them as “grey rhinos.”  This month, we have tried to shed more light on the path the economy and markets could follow leading up to the next recession.  More specifically, interest rates and inflation are key variables to monitor as they are good indicators of where in the economic cycle we are.

Given the current strength of the U.S. economy and labour force, the Federal Reserve will probably have the green light for some prudent tightening in monetary policy in the near term.  Not only is the U.S. economy looking better, but the global economy appears to be moving in the right direction with the International Monetary Fund (IMF) recently increasing their estimate for world economic growth and global purchasing manager indexes hitting their highest levels since 2011.

Inflation should start to move higher but there are likely structural issues that will keep price increases in check, which means interest rates should remain near historical lows.  Do not look to September economic data to gauge the health of the economy.

Hurricanes in Texas and Florida will distort the numbers, and could likely make fourth-quarter GDP and employment releases hard to decipher.  Based on current trends, 2018 could again be a decent year for the capital markets. 

Good growth, interest rates still historically low, and market sentiment that is still not extreme is basically a flashing green light for investors.   Despite the long duration of the current bull market, most retail investors haven’t been big buyers and overall market sentiment remains cautious.  If the U.S. passes any kind of tax reform, economic growth could be even better.

The picture starts to get a bit cloudy after this, however, as recession risks increase and some of the grey rhinos we mentioned last month start to come into play.  More about some of those next month.

What did you think of September’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. 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 only available for sale to tax residents of Canada who are accredited investors. Please read the agreements and/or subscription documents for additional details and important disclosure information, including terms of redemption and limited liquidity.

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save

Save