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2019 Nicola Wealth Kelowna Strategic Outlook
- 1. 2019 Strategic Outlook Brent Thomson
- 4. Pop Culture
- 5. 1994-2019
- 6. Nicola Wealth, 25 years
- 7. The Path Less Traveled
- 8. The Path Less Traveled
- 9. A. Shares in a Mortgage Investment Corporation (MICs) B. Income Producing Real Estate Limited Partnerships (LPs) C. Development Projects LPs D. Real Estate Investment Trusts (REITs) E. Real Estate Mutual Funds
- 10. 1. Dedicated team overseeing >$3.3B of real estate in Canada & USA 2. 180 properties located across Canada & USA 3. 10M + rentable square feet 4. $500M in assets acquired in the last 12 months.
- 11. On The Contrary, Real Estate
- 12. Contrarian Investment Cottonwood Mall, Chilliwack, BC Acquired – February 2019 Partnership with PCI Developments 248,000 sf enclosed mall Vacant 92,000 sf former Target store Remainder of Mall was 94% leased Tenants include London Drugs, Dollarama, Earl’s Restaurant, TD Canada Trust, Burger King & Starbucks. New lease with Save-On Foods to lease up Target vacancy New free-standing Pad/Store to be constructed Strong store performance despite retail landscape Projected IRR: >20%
- 13. Looking at Things Differently
- 15. Up Next…
- 16. 2019 Strategic Outlook Rob Edel, Chief Investment Officer
- 17. Our Agenda An Inconvenient Truth 2018 in Review Four Season Investing The Perfect Storm
- 18. 2018 in Review S&P 500 2018 S&P 500 -4.4%First Correction in 2 Years -10.2% Dec 24, 2018 -19.8% Bloomberg – Feb 22, 2019
- 19. 2018 in Review S&P/TSX Bloomberg – Feb 22, 2019 July 12, 2018July 12, 2018 2018 S&P/TSX -8.9% Dec 24, 2018 -16.8% -8.0%
- 20. 2018 in Review BEAR-o-meter – Global Equity Markets Bond Yields & S&P 500 Both Move up Bonds Prices and Stock Prices Negatively Correlated S&P 500 -19.8% -18.8% -27.2% -23.6% -16.8% -22.8% -34.0% -22.3% -18.2% -16.4% -23.4% -18.5% -26.4% -21.1% -25.8% -30.8% -23.3% -16.2% 20.6% 19.0% 21.5% 24.8% 16.8% 9.8% 29.6% 36.7% 15.0% 10.5% 11.0% 16.4% 17.8% 10.7% 18.2% 25.4% 7.4% 18.6% -40.0% -30.0% -20.0% -10.0% 0.0% 10.0% 20.0% 30.0% 40.0% 50.0% S&P 500 Dow Industrials Russell 2000 Nasdaq Composite S&P/TSX Mexico IPC Argentina Merval Brazil Bovespa Stoxx Europe 600 FTSE 1000 Germany DAX France CAC 40 Italy FTSE MIB Nikkei Hang Seng Shanghai Composite Kospi Bombay Sensex Max Drawdown Recovery
- 21. 2018 in Review Canadian and U.S. Yield Curves Jan 1, 2018 Yield Curve Dec 31, 2018 +60 bps +69 bps Yield Curve Jan 1, 2018 Dec 31, 2018 +28 bps +18 bps -8 bps
- 22. 2018 in Review BEAR-ometer – Fixed Income & Real Assets -3.2% -5.1% -17.7% -9.5% -5.5% -5.9% -17.3% -12.3% -15.1% -12.7% -41.5% -44.3% -76.8% -13.6% -16.2% -23.6% -53.3% -81.2% -46.1% -46.5% 6.4% 4.4% 21.6% 8.6% 5.4% 6.6% 4.6% 20.1% 20.8% 20.1% 33.9% 41.4% 277.9% 10.1% 5.7% 14.3% 18.4% 29.0% 53.7% 62.1% -100.0% -50.0% 0.0% 50.0% 100.0% 150.0% 200.0% 250.0% 300.0% US Agg Bond US TIPS US Leverered Loans US HY Global Agg Bond Global HY Cdn Preferred Shares Cdn REIT's US REIT's Global REIT's Brent Oil WTI Oil WCS Oil Gold Commodities Copper Lumber Bitcoin Horizons Marijuana ETF N.A. Marijuana Index Max Drawdown Recovery
- 23. Four Season Investing S&P 500 Winter Recession Rate cut Min Risk Summer Expansion Rate hikes, Max Risk Fall Slowing Growth High Inflation Reduce Risk Spring Recovery Low inflation, Add Risk
- 24. 2009-Current 1990 – 2000 1949 - 1956 1957 - 1961 1982 - 1987 2002 - 2007 1974 - 1980 1962 - 1966 1970 - 1973 1987 - 1990 1966 - 1968 2002 - 2007 10% 15% 20% 25% 30% 35% 0 2 4 6 8 10 12 Return(CAGR) Years S&P 500 Historical Bull Markets Barron’s – July 2, 2018 Fortune – August 2018 The Economist – October 11, 2018 Bloomberg Businessweek Aug 2018 Four Season Investing – Investor Sentiment Sir John Templeton: Bull markets are born on pessimism Grow on skepticism Mature on Optimism Die on euphoria
- 25. S&P 500 Four Season Investing – Consumer Sentiment (temperature) Mar 2000 – 11 mo. 13 Month Average Apr 1978 - 22 mo Nov 1980 – 9 mo. Feb 1989 – 18 mo. Aug 2007 – 5 mo.
- 26. Feb 1989 - Aug 1990 18 months Mar 1997 - Apr 2001 49 months June 2006 – Jan 2008 19 months Average 29 months Four Season Investing – Wage Growth (pressure)
- 27. December Spike Four Season Investing – Credit Spreads (speed)
- 28. Four Season Investing – Historical Patterns 2018 4.5 Point PE Decline S&P 500 -4.4% S&P 500 EPS +24% 2018 GDP +3.1% S&P 500 Forward P/E Multiple
- 29. Four Season Investing - Historical Patterns – 1984 & 1994 Bernstein US Economics – Jan 8, 2019 1984 GDP +7.3% Earnings +21% P/E – 2 pts 1994 GDP +4.0% Earnings +19% P/E – 3 pts S&P 500 + 6.3% 1985 S&P 500 + 33.0% 1995 S&P 500 + 37.1% S&P 500 + 0.3%
- 30. The Perfect Storm – Donald & Jerome S&P 500
- 31. The Perfect Storm – Hurricane Donald New York Times Op Ed – September 2018 I am part of the resistance inside the Trump Administration “Americans should know that there are adults in the room. We fully recognize what is happening. And we are trying to do what’s right even when Donald Trump won’t.” Betting Odds Trump will be Impeached In his first Term (PredicitIt – Mar 25, 2019) Business Insider – Dec 31, 2018 • March 25 Close – 22% • Pelosi – “He’s not worth it” • Mueller Investigation • No collusion
- 32. The Perfect Storm – Hurricane Donald S&P 500 South China Morning Post WSJ – Feb 19, 2019 USA: 25% tariff on $50 billion, 10% Tariffs on $200 billion (increasing to 25% by end of 2018) China: Proposed or imposed tariffs on $110 billion by December 2018 The Deal (we think) • Easy • China buys more US goods • Harder • Protection of Intellectual property • Reduce government subsidies to Chinese SOE’s • End technology transfer from U.S. companies • Hardest • Enforcement Mechanism – Unilateral? • Existing Tariffs WSJ – Feb 19, 2019
- 33. The Perfect Storm – Donald & Jerome S&P 500 Goldman Sachs Financial Conditions Index & Federal Funds Rate Fed 2018 - Four increases in Federal Funds Rate
- 34. The Perfect Storm – Hurricane Powell S&P 500 Double Line Raising Rates Webcast – Feb 26, 2019 Hedgeye Cartoon of the Day – Feb 21, 2019
- 35. The Perfect Storm – Hurricane Powell December 2018
- 36. The Perfect Storm – Hurricane Powell S&P 500 Hedgeye Cartoon of the Day – Jan 14, 2019 Barron’s – Mar 23, 2019 Three Times in 2019 Once in 2020 Twice in 2019 Once in 2020 No increase in 2019 Once in 2020 One Decrease in 2019
- 37. S&P 500 The Perfect Storm – Hurricane Jerome Unemployment recently touched it’s lowest level in 49 years (Dec 1969) WSJ: Current census estimates only 50,000 jobs/month needed to keep employment stable Current Gap -0.8%
- 38. The Perfect Storm S&P 500 – 2001 Recession (dotcom bubble) Apr 2000 3.8% Apr 2000 5.2% Natural Rate of Unemployment -1.4% 2001 Recession 8 months GDP -0.3% S&P 500 -47.4%
- 39. The Perfect Storm S&P 500 – 1973 – 1975 Recession Unemployment Rate Mar 1969 3.4% -2.4% Natural Rate of Unemployment 1973-75 Recession 16 months GDP -3.6% CPI +12.3% S&P 500 -45% Mar 1969 5.2%
- 40. S&P 500 WSJ – Jan 10, 2019 Fed looking at letting inflation run above 2% The Perfect Storm – Hurricane Powell
- 41. The Perfect Storm Bear Markets & Recessions S&P 500
- 42. An Inconvenient Truth Debt S&P 500 U.S. Unemployment vs. US Budget Deficit as % of GDP WSJ – Mar 21, 2019 CBO US Budget deficit to exceed $1T every year 2022-29 Social Security & Medicare = 40% of all federal spending (excl. interest). By 2029 will be 50%.
- 43. An Inconvenient Truth Debt U.S. Unemployment vs. US Budget Deficit as % of GDP Deficit increasing while unemployment decreasing Last time we saw this: Late 60s Jeffrey Gundlach – Doubleline • Last seven recessions budget deficit increase average 4% of GDP • Last two recessions 5.8% (2001) and 8.8% (2007) • Could hit 13% next recession
- 44. Bond Yields & S&P 500 Both Move up Bonds Prices and Stock Prices Negatively Correlated S&P 500 An Inconvenient Truth US Debt/GDP Bipartisan lack of interest in reducing debt: • Republicans – deficit talk a ploy to roll back tax cuts • Democrats – deficit talk ploy to cut Medicare, Medicaid & social security Washington Post article: A conversation last year between the President and senior advisors took place in which a “hockey stick” spike in national debt was presented. Trump’s reaction: “Yeah, but I won’t be here.”
- 45. IN SUMMARY
- 46. Summary - Farmers Almanac (Old) NWM Forecast It’s Fall – Getting closer to Winter No Recession 2019 Economy and earnings to continue growing Fed to continue tightening 2020 • Create recession in 2020 – 2021 Equities (Dividend Paying) over Bonds • Remember 1985 & 1995 • Look to reduce risk • Diversification • Roots are strong (New) Nicola Wealth Forecast Fed keeps rates low – for too long Result: More severe recession down the road • Asset Bubble – 2001 • Stagflation - 1973-5 All asset classes under pressure Longer term – Inconvenient truth • More debt • Higher Interest rates • Less room for fiscal stimulus • Roots might get severed
- 47. 2019 Strategic Outlook John Nicola, Chairman & CEO
- 48. Where Are We Going?
- 50. Baby Bust 3.8 5.7 2.4 3.7 2.5 5.9 6.4 5 1.6 1.6 1.5 1.8 1.8 2.3 5.5 2.4 0 1 2 3 4 5 6 7 Canada China Germany US Russia India Nigeria The World 1960 2016 2.1 = Break Even
- 51. Memory Lane – Mary Poppins circa 1964
- 52. Mary Poppins Returns 2018 Is 90 the new 60?
- 57. Humble Tweets
- 61. 90% higher 40% lower The 1%
- 63. Older = Richer ? 29.5 28.1 30 32.9 35.3 37.2 38 0 10 20 30 40 1960 1970 1980 1990 2000 2010 2018 Median Age
- 64. Older= Richer Older = Richer https://wallethacks.com/average-net-worth-by-age-americans/
- 65. Top 10% Income Share 31.4% 30.6% 29.8% 26.6% 25.7% 25.4% 25.3% 22.3% 20.0% 22.0% 24.0% 26.0% 28.0% 30.0% 32.0% China US India France Italy UK Canada Norway
- 66. Gini Co-efficient 62.5 48.3 47 46.5 37.9 36.2 32.4 32.1 28.7 24.9 20 25 30 35 40 45 50 55 60 65 South Africa Mexico US China Japan New Zealand UK Canada Switzerland Sweden
- 67. Hey Big Spender Questions What is lowest cost form of debt? How much of mortgage debt has been used to acquire assets or start businesses vs. for personal consumption ? 85%-176% since 1990
- 68. It’s About the Cash Flow Debt Service - P and I increase from 12-14.9% since 1990 Debt Service - Interest only decrease from 10-6.5% since 1990
- 69. Spendthrift Canadians? 11 11.55 12.42 13.05 12.98 1.85 1.95 2.05 2.16 2.24 9.1 9.6 10.36 10.89 10.74 0 2 4 6 8 10 12 14 2014 2015 2016 2017 2018 Total Assets Total Liabilities Net Worth
- 70. By the numbers Over 4 years assets have risen by $2 Trillion. Liabilities by $400 Billion. LTV rate now at 18% vs. 17% in 2014. Declining home prices and equity markets impacted 2018 numbers.
- 71. Our Asset Allocation CDN/US CDN / Foreign (Private & Public) Bonds Mortgages Private Debt Hedge Funds Precious Metals Real Estate 24% Equity 36% Fixed Income 35% Alternative 5% Nicola Wealth Client Composite Model March 2019
- 72. Asset Allocation for HNW Investors Globally Source: Capgemini
- 73. Multi Family 20% Commercial 11% Farm/Timber 11% Public Equities 23% Securitised Debt 33% Gold 2% 42% Global Investable Assets Why would this be 60-75% of an Investment Portfolio?
- 74. Issues o Illiquid asset class o Hard to diversify o Significant minimum investment o Higher fees on committed capital o Due diligence on managers o Fund of funds likely best option
- 75. Northleaf PE Returns vs. MSCI World Returns to June 30, 2014. Northleaf returns gross of Northleaf fees.
- 76. Where has the low hanging fruit gone? Getting harder all the time2%< historical Still expensive How low can they go? Source: Statscan https://www.quandl.com/data/MULTPL/SHILLER_PE_RATIO_MONTH- Shiller-PE-Ratio-by-Month Source: NAREIT
- 77. Private debt (mortgages and corporate lending) 2%< historical Still expensive How low can they go? Asset allocation Value investing Dividend growth Private Equity Build to own Value add Modest leverage Where has the low hanging fruit gone? Source: Statscan Source: NAREIT https://www.quandl.com/data/MULTPL/SHILLER_PE_RATIO_MONT H-Shiller-PE-Ratio-by-Month
- 78. Market Cycles Markets more expensive Lower probability for above average future returns Markets less expensive
- 79. Market Timing Should you try and time this? No Should you focus on your tactics? Yes Asset Allocation Rebalancing Defensive Cash Flow Assets
- 80. Price is 3 to 4 times as volatile as cash flow for both real estate and equities
- 81. Seven Habits of Highly Ineffective Investors
- 82. What if Everyone is Above Average? 2006 Survey of 300 Fund Managers 76% said they were above average The other 24% said they were average 100% were average or better?
- 83. The Deadly Trio Cognitive Dissonance (I agree with every fact That agrees with me) Over Confidence (a Bridge - or apple - too far) Confirmation Bias
- 84. Gambling with House Money Investors increase their aggressiveness when they win first. Can we up the minimum bet?
- 85. Loss Aversion $2 Gain = $1 Loss
- 87. Behavioural Finance Can you sell when you are winning and buy when you are losing ?
- 88. 3-5% annual loss of return The Impact of Emotion in Investing 5% worse In 12 monthswww.investmentexecutive.com
- 89. Managing Assets More Efficiently Alternative Strategies, 15.0% High Yield Bonds, 7.3% Preferred Shares, 4.5% Canadian equitries , 17.0% Real Estate, 20.0% Mortgages, 11.0% Bonds, 9.0% Foreign Bonds, 5.4% Private Equity, 4.0% Foreign Equities, 12.1% 4.6% Re-Balance -2.3% 2.3% for 2018 (Morningstar Neutral Balanced =-4.7%)
- 90. Spock or Homer?
- 92. Know Thyself (avoid overconfidence) Embrace Uncertainty (Minsky Moments) Play the Odds (Avoid Loss Aversion) Diversification in asset classes but focus within them Accept Pain (necessary path for growth) Behaving Well
- 94. The 4% Rule 50% success https://www.onefpa.org/journal/Pages/The%204%20Percent%20Rule%20Is%20Not%20Safe%20in%20a%20Low-Yield%20World.aspx
- 95. A Couple’s Tale Bob and Linda are both age 60 . In good health and considering retirement . Here are the other facts: • Bob is a lawyer and Linda a dentist. • They are both incorporated and have personal, registered, and corporate portfolios of $2M each • Bob’s portfolio is best represented by Morningstar’s Balanced Index. • Linda’s portfolio is invested with us in a Core Model • They want to know the likely impact of withdrawing 4% of their capital annually and adjusting that to inflation. • We recreate that model for them going from January 2000 to December 2018.
- 96. How Well Does It End? $2.0M $2.0M$1.8M $1.8M$1.7M $3.7M $- $500,000 $1,000,000 $1,500,000 $2,000,000 $2,500,000 $3,000,000 $3,500,000 $4,000,000 Bob 60/40 Linda Start Income End
- 97. A Couple’s Tale What Happened? • Bob’s indexed income greater than his overall return. • 85% of Linda’s return from cash flow so less volatility and no need to sell assets during negative years such as 2008. • SWP have greater negative impact in losing years. • Bob has 6 losing years out of 19 with a combined loss of 28% . Linda has two losing years with a combined loss of 7%.
- 98. What Is Next? Real and Secular Road Bumps Ahead Behave Well We’ve Been Here Before
- 99. THANK YOU This presentation contains the current opinions of the presenter and such opinions are subject to change without notice. This material is distributed for informational purposes only and is not intended to provide legal, accounting, tax or specific investment advice. Please speak to your Nicola Wealth Advisor regarding your unique situation. 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. All investments contain risk and may gain or lose value. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.
Editor's Notes
- Good evening everyone, For those of you here whom I have not yet met, my name is Brent Thomson, the managing partner of the Kelowna Office. On behalf of John Nicola, Rob Edel, and the entire Kelowna team it is my pleasure to welcome you to our 2019 Strategic Outlook.
- I would like to begin this evening with a question… What were you doing in 1994? Historians have noted that 1994 was a rather seminal year for news events.
- For example… In 1994, NAFTA was established Nelson Mandela was inaugurated as South Africa's first black President, Netscape was founded (the beginning of digital music sharing), And in 1994 Jeff Bezos founded a company called Amazon,
- 1994 was a big year for Pop culture as well… The sitcom Friends debuted in 1994, And the cult classic movie Pulp Fiction and The Shawshank Redemption were released.
- Which brings me to the point and ANOTHER 25th ANNIVERSARY. You see, 1994 was also the year John Nicola founded the John Nicola Financial Group. So, it appears that the music world lost a “rock star” but the financial world gained one…
- From our beginnings in False Creek, we have gone on to build a national firm, with offices in both the West Coast and East Coast of Canada We have transitioned from a firm that began by investing in “stocks and bonds” to having built an institutional investment platform - providing our clients access to assets that are usually reserved for pension funds and private institutions. As I look back over the firm’s history, there is a common thread that runs through our story - it was our contrarian approach OR taking the path less traveled…
- Warren Buffett, himself often viewed as a contrarian investor, once said that as an investor, it is wise to be “fearful when others are greedy and greedy when others are fearful.”
- Back in 1996, John Nicola wrote a newsletter titled, “The Crash of 1997”. On p. 3 of this newsletter there was a section titled, “How do our Financial Planners Invest? I thought it would be interesting to review John’s portfolio back in 1996…we can see that GICs and Bonds accounted for 69% of his portfolio, equity was at 22% and income producing real estate comprised 9% of his portfolio. Reading through the paragraph he writes, “Income producing real estate is a new investment which I am cautiously adding to my portfolio”, and he closes by saying, “High cash flow real estate will probably increase to 20% of my portfolio within 5 years”.
- Six months later John wrote the following memo to all of our clients - where he outlined the features of various real estate investments, which included; Shares in MICs, 2) Income Producing Real Estate LPs, 3) Development Projects LPs, 4) REITs, and 5) Real Estate Mutual Funds And at the end of the memo was a simple box, where we asked our clients to reply back to us if there was any level of interest in acquiring some of these real estate assets. The results back were a resounding YES….
- As I reviewed our Nicola Wealth real estate website this weekend I can provide you with the most updated facts of our real estate portfolios: We have a dedicated real estate team overseeing $2B of real estate in Canada & USA We have 180 properties located across Canada & USA We have over 10M rentable square feet And just this last 12 months we have acquired over $500M in assets ALL this in the last 22 years…
- To summarize our theme of, “The Path Less Traveled” I mentioned earlier that in 1994 Amazon was founded. One of the aftershocks of this company being created was the, “Amazon Effect”, which refers to the IMPACT created by on line shopping and e-commerce on the TRADITIONAL brick and mortar business model. Investing in retail commercial real estate, and shopping centers has fallen out of favor…
- I want to provide you with a recent example of our philosophy in action. In February of this year our Nicola Wealth real estate fund acquired the retail center, Cottonwood Mall, in Chilliwack in partnership with PCI Developments. The property is comprised of a 248,000 sf enclosed shopping mall. When Target closed its entire catalogue of stores in Canada back in 2015 - this mall was left with a 92,000 sf empty space. The remainder of the Mall was 94% leased with tenants reporting strong sales. Tenants include, amongst others; London Drugs, Dollarama, TD Canada Trust, and Starbucks. During due diligence a new lease was signed with an anchor tenant, Save-On Foods A new free-standing Pad/Store is to be constructed Strong store performance despite retail landscape Projected IRR: >20%
- Being contrarian goes beyond investment decisions. It means looking at all aspects of our business differently. To paraphrase Warren Buffet, it has allowed us to find opportunity where others in the industry were fearful.
- We are proud of the work we have accomplished over the past 25 years, and we are very excited about what the future holds. And as always, thank you for allowing us to be your trusted advisor these past 25 years…
- I would now like to invite our Chief Investment Officer Rob Edel to the stage to share his insights on what shaped 2018 and what we might expect in 2019. Rob…
- Agenda: Look at what happen last year Which was not a very good for investors Next, we try and determine where are in the current business cycle Looking at what we are calling four season investing We highlight a couple of events that heavily influenced markets last year The perfect storm Before finally discussing some longer term issues we are keeping an eye on
- Looking a the markets last year, first the S&P500 Returned -4.4% last year, a disappointing result The year got off to a shaky start , falling just over 10% in late January, early February This was the first correction (decline of over 10%) in 2 years Markets remained choppy Until around the beginning of Spring – Bottoming March 23rd to be exact The beginning of Spring More that recovering the losses earlier in the year It was all sunny skies and good returns until, strangely, topping out on September 20th, the end of summer At which point US stocks began trending lower, bottoming on December 24th, which is normally a very slow trading day From it’s top on September 20 until December 24th, the S&P 500 fell just under 20%. Not a bear market, which is 20%, but very close Like earlier in the year, we then had a pretty good rally into the year end The S&P 500 is now back up over 20%, but would need 25% to recoup the correction of nearly 20% last year
- Turning to Canadian stocks The S&P/TSX was down a little more than the S&P 500, falling nearly 9% We also saw the same seasonal pattern, with an 8% fall early in the year And Stocks bottoming out around the beginning of Spring. Summer ended a little earlier in Canada, however, as the market topped out on July 12th And by December 24th, had fallen nearly 17%, not quite as much as US stocks, And also not a Bear Market. Again we have seen a strong rally to end 2018 and the start of 2019,
- What was interesting about the market last year, however was that everything was down There was really nowhere to hide Here we have what we will call our Bear o Meter, which will show when a market is down over 20%, thus in a Bear market As mentioned, Canadian and US stocks were down, But notice the Russell, which is small cap, were down over 27% - Bear Market Same for the tech dominated NASDAQ, down nearly 24% Mexico was also in a bear market As was most of South America And a lot of Europe In Asia Only India avoided a Bear Market China was down over 30% It was a particularly tough year for the Emerging Market The recover has almost been the mirror image With the Emerging Market doing particulariy well
- Looking at the bond market and the U.S. Yield curve, the strength continued strength of the U.S. economy can be seen by the upward shift in the yield curve. The curve also flattened, however With 2 year yields up 60 bps While 20 year yields only increased 28 bps What is also interesting is this kink in the yield curve With 2 year yields ending the year above 5 year yields This is not normal and definitely something we will wan to take a closer look Turning to Canada, We also saw the yield curve flatten With 2 year rate up 18 bps But 10 year yields actually fell 8 bps Showing some weakness in Canadian economy We also saw a slight kink in the short end of the yield curve, But not as dramatic as in the US.
- Looking outside of stocks Bonds also did poorly with interest rates going up And credit spread widening Though the US dollar appreciated nearly 9% against the C$ So in Canadian dollar terms, foreign fixed income returns actually looked pretty good Real Estate also did poorly, with REIT’s down around 12% Though NAV weren’t down Our hard asset real estate pools ended the year in positive territory Real Assets were also lower With commodities like: Oil down over 40% Canadian WCS down over 76% Dr. Copper down 24% Lumber -53% And even the Bitcoin and Marijuana with big loses Like stocks, it was a mirror image in the recovery So what was going on in the market last year? The concern would be that the market was signaling the start of a recession
- The fact stocks tended to fall in sync with the seasons last year reminded of the old Peter Sellers classic Being There, Playing the part of a simple minded gardener, Sellers described his world of gardening, but those around him believed he was talking about the economy He said: Growth has its seasons. There are Spring and Summer, but there are also fall and winter. And then Spring and Summer again. As long as the roots are not severed, all is well and all will be well. This describes the business cycle very well Summer We have expansion With higher interest rates It’s a good environment for investment returns So investors should be prepared to take more risk Fall Growth is still strong, but slowing Inflation is increasing Investors should begin looking at reducing risk Winter Recession Interest rates will be coming down Investors should have minimum risk levels Spring Is a time of recovery There will be growth in the Spring Time to begin adding risk back into the portfolio We think that we are in Fall, getting closer and closer to winter But we don’t know how close of when winter will arrive
- In the world of the Gardener, this is easy You just look at the calendar Winter last year started on December 21st Same for 2019 With the business cycle and bull markets, it’s not so easy The concern is if you look at a chart of all historical bull markets by duration You can see that the current bull market is now the longest in history Because of this many are predicting the end of the bull market As can be see by these magazine covers from last year BusinessWeek – A Very Long Bull Barron’s - The Bulls Final Count Down, best before 2020 The Economist - The Next Recession, how bad will it be? But duration isn’t what ends a bull market of the business cycle and from a return perspective, average annual returns have actually be low Negative sentiment can actually be a good thing As Sir John Templeton once said Bull markets are born on pessimism Grow on skepticism Mature on optimism Die on euphoria Given the low returns and general sentiment, we appear to be close to the skeptisim stage than euphoria So what do you do to determine when the season will change from Fall into Winter?
- Well, forecasting the weather, there are a number of indicators and tools we can use Like a thermometer, barometer, wind speed So let’s look at the economic equivalent First one is consumer sentiment Consume spending is 70% of the US economy So gauging the mood of the consumer is very important Here is a chart of the University of Michigan Consumer Sentiment indicator The highlighted boxes are when the US economy is in recession As can be seen by the red circles, Once consumer sentiment peaks, On average its taken 13 months before the economy has gone into recession. We saw a slight dip in December And we’ll have to watch to see if this is a trend But even if December was the peak, we wouldn’t have a recession until at least 2020
- Wage growth is another useful forecasting tool Higher wage growth is a key ingredient leading to sustainable inflation And higher Inflation is what causes the Central Bank to raise interest rates Thus driving the economy into recession, or winter As can be seen with average hourly earnings With the outlined boxes again being time periods when the US is in recession Before the last three recession, wage growth has risen above 4% The last three times wage growth has hit the 4% level, a recession has followed But on average there has been a lag of about 29 months Wage growth has been moving higher and is something to watch But it’s still only about 3.4% so hasn’t hit 4% yet So still room on this indicator
- Once the central bank starts to tighten, how do we know when it’s starting to impact companies and their ability to borrow, thus slowing economic growth? credit spreads are a good indicator for this. Again in this chart, highlighted area is recession, you can see rising credit spreads has been a good warning signal. But so far, spreads have remained quite low. We did see a spike in credit spreads in December, but it was short lived Overall, it’s still pretty easy for companies to access capital
- In forecasting the weather A useful tool is to look at historical weather patterns to determine if the presence of similar conditions could lead to the same outcomes SO let’s list some of the patterns we saw last year The S&P 500 decline 4.4% The P/E multiple also declined 3.0 points Because S&P 500 EPS was actually up 24% Not only was earnings strong, but so was the economy GDP was up 3.1% Stocks may have gone down, but it wasn’t because of the economy or earning, They were actually very strong And as a result – stocks became cheaper It actually should have been a pretty good environment for markets
- When might we have seen a similar pattern? 1984 and 1994 1984 S&P 500 +6.3%, trading in a fairly narrow band But the economy was very strong GDP +7.3% Earnings were +21% And the P/E multiple declined 2 points 1985 – Market was up 33% 1994 – a similar story S&P 500 +0.3%, trading in a fairly narrow band But the economy was very strong GDP +4.0% Earnings were +19% And the P/E multiple declined 3 points 1995 – Market was up 37% Based on these historical weather patterns, 2019 should also be a pretty good year
- To use a weather analogy – It was a perfect storm If we turn to our satellite weather map We can see the convergence of two category 5 hurricanes threatening to hit the US mainland at the same time Namely Hurricane Donald And Hurricane Jerome
- Fist Hurricane Donald Probably the most controversial and divisive US president ever This chart is from the website Predictit, an online betting site Different than normal opinion polls in that it is people backing up their opinions with their hard earned money This graphs shows the betting odds of President Trump being impeached in his first term It’s moved lower lately, But is still quite high Say what you want about President Trump But a President in trouble is not good for the market This chart , from the Brookings Institute is probably more disturbing Showing the level of turnover at the White House Which is unprecedented compared to previous administrations Run through the list the number of times Trump has needed to look for replacements for key positions in the administration Remember last September when the NY Times ran an Op Ed from an un-named Senior official in the Trump Administration It was meant to reassure the public That there were “Adults” in the room protecting us from a reckless President With all this turnover, are there any adults still left?
- This is scary stuff, and sometimes we are left wondering why the market did as well as it did given the geopolitical risks But this is not generally what drives markets. The market doesn’t know how to value or discount the “Crazy Trump” risk, so it generally doesn’t The real Hurricane Donald that the market was watching was the trade war between the U.S. and China. The US started off with 25% tariff on $50 billion of Chinese imports Before adding 10% tariffs on an additional $200 billion of imports Which was to ramp up to 25% by the end of 2018 China countered with their own tariffs on $110 billion of US exports Which represented nearly everything the US sent to China Near the end of the year, however, this hurricane gradually began to lose strength The US and China started meaningful negotiations Which resulted in the US eventually agreeing not to increase the tariffs to 25% And though no deal has been officially announced The framework of a deal is being leaked It still might fall apart But in general, we would downgrade this hurricane down to a tropical storm Longer term, however, the damage has been done, and been brewing for a while – before President Trump As can be seen in this chart from Barron’s, trade policy uncertainty began moving higher before Trump was elected In the 1990’s trade grew twice global GDP, since 2012, only slightly higher 2016 more jobs were gained from on shoring than offshoring Not since 1970 has this happened A recent Bain survey found 48% of companies are looking to find new suppliers We might get a trade deal, but the trade war with China is not going away
- As can be seen with this slide It’s not just China Trump has been fighting with He’s also been battling with Jerome Powell, Chairman of the US Federal Reserve Which is our second category 5 hurricane Trump is quoted as calling the Federal Reserve a bigger problem than China and And basically what he was upset about was the continued tightening policy of the central bank, which he called loco Here in this bloomberg chart You can see the overnight fed funds in green being ratcheted up With the white line, the Goldman Sachs financial conditions index closely following Tightening financial conditions are bad for economic growth Which in turn are catastrophic for Trumps re-election plans
- And Trump had a point One of things Trump and the market was watching was not only what was going on in the US economy But what was happening with global growth, which was turning lower As can be seen in this chart form Doubleline US growth was still good, but Japan Germany UK France Italy Canada All were seeing a deceleration Of particular concern was, and still is China The Fed was raising rates while the rest of the world was slowing This was seen by the market increasing as a mistake by the Fed
- This next chart clearly shows the markets angst Again, the outlined boxes are indicate recessions The blue line is the slope of the short end of the yield curve – comparing the yield of the five year treasury less the two year treasury A positive number is normal and means the slope is positive, with five year rates greater than two year rates. When the line is moving higher it means the slope is steepening When it is moving down, it means the curve is flatening. When it is negative, it means two year rates are greater than 5 year rates This is highly unusual And historically been a near perfect indicator of a recession As can be seen by these red circles And it makes sense Why would anyone buy a five year bond yielding less than a two year unless they believed rates are going to drop, like in a recession Also for banks, who borrow short and lend long, this becomes unprofitable Which means credit growth stalls As you can see in December, the blue line turned negative Meaning the 2/5’s yield curve had inverted
- This was essentially a desperate cry from the Market for the Fed to stop increasing rates They were making a policy mistake and threatened to drive the economy into recession Normally most people look at the 2 year versus the 10 year as the important recession indicator And it still hasn’t inverted But the short end of the curve inverting is not a good sign And Chairman Powell and the Fed took the hint In what is now referred to as the “Powell Put” The Powell and the Fed heard and essentially put on hold any more rate increases . This chart taken form the Barron’s shows In September of last year, the Fed was indicating they would raise rates Three times in 2019 and once in 2020 By December this has been reduced to twice in 2019 and once in 2020 Now, with the Powelll pivot, no increase in 2019 and one in 2020 The market believes they will cut in by December (60% chance)
- So is the Fed done? Can we downgrade this Cat 5 Hurricane? Here is what is concerning the Fed In this Chart, the brown line is the unemployment rate While the smoother blue line is what is referred to as the long term natural rate of unemployment This is the unemployment rate where the economy is in balance, with employment providing neither an inflationary or deflationary influence It’s been moving gradually lowered since the 1980’s, but typically doesn’t change much form year to year Again, outlined boxes indicate recessions As can be seen by the red circles, when the unemployment rate has dipped well below the natural rate of unemployment, a recession has soon followed. This makes intuitive sense as low period of unemployment would correlate with an economy that is running too hot with inflation increasing The central bank would be inclined to tighten monetary policy in this environment As can be seen with this last circle, the unemployment rate is currently well below the natural rate, and threatening to go lower Recently the unemployment rate hit its lowest level in 49 years And according to the WSJ, only 50,000 new jobs a months are needed in order to keep up with population growth – meaning the brown line is likely to go lower What are the implications of this Well let’s look at our historical patterns again for examples Oh…and you aren’t going to like either of these
- In this chart – we have the late 1990’s The green line in the unemployment rate The white line is the S&P 500 The dotted red line is the natural rate of unemployment In April 2000 The unemployment rate was 3.8% - same as it is now And the natural unemployment rate was 5.2% This left a pretty wide gap of 1.4% - currently the gap is 0.8% The S&P 500 On the far left here, you can see a correction in 1998 of about 19% Similar to what we saw late last year Then we saw a nice rally, with stocks up over 60% over the next two years That’s the good news Because right about when that gap was at it’s widest, the market topped out And started falling The Grey box here is the 2001 Recession It lasted about 8 months With GDP falling 0.3% And a Bear market with the S&P 500 down close to 50% The Central bank left monetary condition too loose and the result was an asset bubble - the famous dot com bubble And a relatively short recession This is what the Fed could be risking if they delay too long in raising rates It gets worse
- In this chart in the late 1960’s We have an unemployment rate in March 1969 of 3.4% With the natural unemployment rate still of about 5.2% Leaving a gap of 2.4% - even wider Soon after you can see the 1969-70 recession Lasting 11 months and a 0.8% contraction in GDP With a Bear market decline of just over 30% But the real pain was felt a few years down the road Even though the S&P 500 recovered and rallied nearly 90% over the next three years By letting the employment gap widen to this degree without tightening monetary policy, the Federal Reserve was setting the stage for an increase in inflationary expectations that would eventually require a more aggressive tightening cycle by then Chairman Paul Volker Which would lead to the recession of 1973-5 A nasty 16 month contraction of 3.6% Which saw inflation peak out at over 12% And the S&P 500 fall nearly 45% More than wiping out all the gains
- The Federal Reserve has a lot of things to look at As there are many variables to consider in making their economic forecast But because of the experience of the 1973-75 recession Inflationary expectations will be one of the key factors Right now, inflation is not a problem In fact it’s only now beginning to reach the Fed’s 2% target Though wage growth, as we mentioned earlier is starting to move higher The Fed has even talked about letting run a little hotter for a period of time Giving them a little more room to cut rates during the next recession But they will be very cautious in letting expectations move meaningfully higher As happened in the storm of 1973-5 In trying to prevent or delay a recession, if the Fed let’s inflationary expectations move meaningfully higher They might be trading off a mild recession now, for a more severe recession down the road It also makes leaves some uncertainty for what will happen early next year Don’t raise rates, or even cut rates, and the let the economy run hotter in the short term, but have to deal with a bigger recession down the road Or raise rates and create a recession in 2020, but keep inflationary expectations anchored
- Or as can be see in this cartoon, The forecast for 2020 could be 60 degrees and sunny Or snow
- Longer term, beyond what might happen in the current cycle, we have some concerns, what we are going to describe tonight as an inconvenient truth An Inconvenient truth of course refers to global warming and how it is more convenient to either ignore or deny it is caused by the burning of fossil fuels than to proactively come up with a solution that is invariably inconvenient With the economy, an inconvenient truth is debt, and how the growth of debt globally threatens the global economy in the future We will mainly talk about US government debt tonight But it really is a global issue with most countries on an unsustainable path In the US, the CBO is forecasting the Federal deficit will exceed $1 trillion a year for the next eight years Most of the growth is due to an aging population and comes from entitlement spending like social security and medicare Which presently comprises about 40% of all Federal spending But is expected to reach 50% by 2029
- Recently, however, the problem has even grown beyond the entitlement spending issue In this Bloomberg chart The white line is the unemployment rate and the yellow line is the US budget deficit as a % of GDP These line tend to follow each other fairly When the unemployment rate is going down, and the economy is strong, we would expect the budget deficit to go lower Recently, however, we see a break, unemployment continuing to move lower but the Deficit also turning higher How can we ever expect to reduce government debt if we can’t even reduce it when times are good? When was the last the last time this happened your not going to like this, the late 1960’s. Jeff Gundlach calls this a suicide mission The last two recessions the deficit was increased to 5.8% and 8.8%. Based on starting from a 4% deficit, he feels we could see 13% in the next recession. This could leave the US in a tough spot in the next recession The Fed can’t cut rates enough because they were able to raise them enough And fiscal stimulus will be constrained because the deficit is already very high.
- There is a limit to how much the market will let the US borrow Eventually the bond market will say enough and take interest rates much higher Our concern is there is very little interest in Washington to prevent this A bipartisan lack of interest in fact Reducing the deficit will require bipartisan support from both the Republicans and the Democrats Which is non existent right now Everyone knows future growth of the deficit is unsustainable but there is no appetite to change it Republicans believe any talk over reducing the debt is really a play to roll back their tax cuts Democrats believe deficit talk is a ploy to cut social spending Even the President, King of Debt, has no interest According to a recent Washington Post article, during a conversation between Trump and senior advisors a chart with a hockey stick spike in national dent was presented. Trumps reaction, “Yeah, but I won’t be there”. Everyone is kicking the can down the road And eventually it will require a debt crisis and a spike higher in yields before politicians in Washington deal with the problem.
- So where does this leave ? We think it’s still Fall But we can’t avoid the inevitable Winter is coming The question is when And how bad the winter will be
- Now with the weather, if we wanted to know how bad the upcoming winter as going to be, we might pick up a copy of the Farmers Almanac But we would like to point out that there are actually two Farmer’s Almanac’s The old Farmer’s Almanac (1792) and the new Farmers Almanac (1818) And last year their predictions for the upcoming winter were very different For the economy and the markets, we have created our own our forecast We still believe it’s fall, but we are getting closer and closer to winter We don’t see a recession this year, and maybe even in 2020 This can be a good environment for returns and risk assets Dividend paying equities over bonds Remember 1984 & 1994 This is also an environment, however, to start reducing risk Don’t think it will be a severe recession – not a lot of imbalances In the words of Chauncey Gardiner – the roots are strong Diversification Now because out marketing group has decided to rebrand our firm as Nicola Wealth Like the Farmers Almanac, this gives us another forecast If the Federal Reserve keeps rates to low for too long Or even starts cutting rates to prevent a recession Asset bubble Stagflation Nothing does well in this environment The roots are severed Even worse in the longer term if debt is increased Lead to higher inflation and less potential fiscal stimulus