The following commentary represents the opinions and analysis of Doug Nelson, President, Portfolio Manager, Nelson Portfolio Management Corp. as at July 12, 2018. Market and index returns noted below are based on the price changes for each quoted item for the period ending June 30, 2018. Market Statistics: Source: https://ca.finance.yahoo.com, https://ycharts.com.

• The Toronto Stock Exchange Composite Index increased by approximately 5.92% from April 1 through to June 30, 2018. The bulk of this return was generated by the large increase in the price of oil and energy stocks (more on this to follow). The increase from April 1 was similar to the gain we saw last fall. See Table 1.
• Looking back over the past year, due to the fluctuations in the Canadian market (as measured by the S&P/TSX Composite Index), it has been a sideways market that has traded within a range from 15,000 to 16,400. This is a 10% range. We can see this with the green lines noted in Table 1 below. The returns for the index were flat from July 2017 through to the end of March 2018. Measuring the market from the high point of the trading range, we also see that the market has been flat from December 2017 through to June 30, 2018. It has been a “sideways” market environment in Canada over the past 12 months.
• The S&P/TSX Composite Index generated a return of +5.92% over the past 3 months, but has a year to date gain of only +0.42%. The 12-month return is +7.22%. You can see that the bulk of the return over the past 12 months came from the rise in the market these past 3 months.
• The question today is: will we see the Canadian market fluctuate back down to the 15,000 level OR will we see it move to new all-time highs beyond the 16,400 level? So far, from July 1 through to July 11th we have seen a positive gain, with the index now trading at the 16,534 level. Most of this has been a concentrated gain delivered by the energy sector. This type of market moving activity is similar to what we saw in 2016, where the strong gains in the energy sector (+65%) resulted in strong gains for the stock market index (+29%). However, these gains didn’t last as we saw the energy sector decline by almost 25% (from January 1, 2017 through to February 9th, 2018), which in turn also drove down the overall Canadian stock market -1.66% for this 13-month period of time).

Table 1: S&P/TSX Composite Index (^TSX) from July 1, 2017 through June 30, 2018. Source: YCharts.

 

• In short, as goes energy, so goes the Canadian market. The past three months has been no exception.
• All the major sectors in the Canadian market over the past three months posted positive returns.

    The Financial Services Index (XFN): Last 3 months: +1.03%. Year to Date: -3.18%. Last 12 months: +5%. For the banking sector this is a very low return. It is interesting to see that the bulk of the returns for this sector over the past year took place in the July to December 2017 period of time. Year to date the return in the financial services sector has been negative.

    The Energy Index (XEG): Last 3 months: +16.02%. Year to Date: +6.85%. Last 12 months: +19.84%. Note how all of the returns for this sector have occurred in just the last few months. In the first three months of 2018 the return for this sector was -7.91%.

    The Materials Index (XMA): Last 3 months: +7.26%. Year to Date: +2.28%. Last 12 months: +10.6%. Again, we see that the bulk of the returns in this sector over the past year have occurred in the last 3 months. In the first three months of 2018 this sector had a return of -4.64%.

    The Real Estate Index (XRE): Last 3 months: +3.36%. Year to Date: +3.36%. Last 12 months: +6.63%.

• The defensive holdings picked up where they left off in the first three months of the year and continued to decline in value.

    Canadian Broad Market Bond Index (XBB): Last 3 months: +0.07%. Year to Date: -0.90%.
Last 12 months: -2.1%.

    US Investment Grade Corporate Bonds (XIG): Last 3 months: -2.55%. Year to Date: -6.42%.
Last 12 months: -5.5%.

    US High Yield Bonds (XHY): Last 3 months: -0.68%. Year to Date: -4.39%.
Last 12 months: -5.58%.

    North American Preferred Shares (XPF): Last 3 months: -0.11%. Year to Date: -1.84%.
Last 12 months: -2%.

• The US and other international markets have not been as strong year to date as they were in the last 6 months of 2017:

    S&P 500 Index (SPY): Last 3 months: +2.93%. Year to Date: +1.66%. Last 12 months: +12.19%. Again, we see the bulk of the gains were in the last 6 months of last year rather than so far in 2018.

    Europe / Asia / Far East (EFA): Last 3 months: -3.89%. Year to Date: -4.75%. Last 12 months: +2.71%.

    Emerging Markets (XEM): Last 3 months: -7.92%. Year to Date: -3.27%. Last 12 months: +6.1%.

    Gold (GLD, in USD): Last 3 months: -5.68%. Year to Date: -4.04%. Last 12 months: +0.53%.
Gold has traded sideways over the past year.

    Canadian Dollar vs. US Dollar: Last 3 months: The Canadian dollar has declined 1.96%. Year to Date: -4.39%. Last 12 months: -1.37%. Over the past year the US dollar has gained in value against the Canadian dollar. This is good if you hold US dollars, which we do. But the gain in the US dollar means the exchange rate is lower and less favorable today when you buy US dollars vs. 6 and 12 months ago.

• To put these figures into perspective, let’s look at some simple, comparative portfolios.

    To build the portfolio I will use 4 securities: i) The broad Canadian bond market bond index (XBB) for the defensive component of the portfolio, ii) the S&P TSX Index for the Canadian equity component, iii) the S&P 500 index for the US equity component and iv) the Europe / Asia / Far East Index (EFA) for the global component. The returns for each of these components have been noted above in this commentary.

    The Conservative Portfolio mix will be 65% defensive and 35% growth.

    The Balanced Portfolio mix will be 50% defensive and 50% growth.

    The Growth Portfolio mix will be 35% defensive and 65% growth.

    Here’s the layout for these portfolios:

Table 2: Sample Portfolio Designs.

    Here are the returns for these comparative portfolios:

Table 3: Comparative Portfolio Returns:

    To put these returns into context, no additional portfolio management fees have been added to the portfolio cost. Many typical advisor scenarios would see additional fees of 0.75% to 1% added to the cost of this type of portfolio. This means that the actual returns above would be reduced by another 0.75% to 1%.

    These returns are based on a combination of the indices noted in the first chart above.

The NFC Tactical Asset Allocation Pool returns for these same periods of time as listed below (Source: Croesus software). This is the actual return on the overall pool value after all fees and expenses have been drawn from the pool as measured on a cash basis:

    Last 3 Months:       +1.90%

The pool generated a return higher than a typical Balanced Portfolio shown in Table 3. If you were to subtract fees from the typical growth portfolio above, the actual return for the year may have been only 1.24% to 1.50%.

    Year to Date:         +2.70%

The pool generated a return that far exceeded all sample portfolios in Table 3. If you were to subtract fees from the returns in the table above, these portfolios would see returns in the -1% to -1.5% range.

    Last 12 Months:     +4.55%

The pool generated a return similar to a typical growth portfolio in Table 3. If you were to subtract fees from the returns in the table above, the typical growth portfolio return may be in the +3.65% to +3.85% range.

What can we conclude from all of this data?

1. Markets and individual sectors within those markets have continued to be volatile. Some sectors performed well during the last 6 months of last year but have lagged so far this year. With other sectors and markets, we see the opposite, where the returns in these sectors have been better during the first 6 months of 2018 vs. the last 6 months of 2017. Depending on the periods of when you measure the rates of return, you can end up with a wide range of results. This is the reason why I take all of this time and space to digest in detail exactly how markets have performed, which in turn helps me make sure that I make good decisions with this information.
2. If we bundle the market returns into sample portfolios (Table 2), we can see what the returns for these sample portfolios (Table 3) have been over these same periods of time. When we evaluate things from this perspective, the overall returns may not have been as high as you would have expected.
3. With this information in mind, despite the lower overall returns we have seen in the market, the NFC Tactical Asset Allocation Pool has continued to perform well.

So, why did the markets perform like this?

In the March 30th, 2018 commentary I wrote the following:

• While there are many reasons for this, one of the greatest issues to arise over the past three months has been the growth in the US economy and the concern that it may start to grow too fast. When an economy starts to grow too fast, inflation starts to show up in many areas such as the cost of various goods as well as increases in wages. To keep the economy running smoothly, the central bank will typically increase interest rates, to help cool down the economy.
• One of the major fears to come out of the last few months has been the fear that central banks may need to increase interest rates sooner and to a larger degree, which is typically both negative for both stocks and bonds.
• The U.S. market has also posted some negative returns (from January 1 to March 30, 2018), even though overall the U.S. economy continues to grow at a solid rate. Does this mean that this correction is temporary and / or overdone and that we can expect to see markets rally further from here? And will the Canadian market see a rebound this year, from being one of the worse performing equity markets last year to one of the best performing markets this year? These are the big questions facing investors today.

As a follow up to this I’d like to add the following:

• The number one topic today is about Tariffs and Trade Wars. Initiated by President Trump, additional trade tariffs have been added to literally dozens of goods that are commonly traded between nations. A tariff is an additional tax on an item entering another country, which in turn makes that item more expensive to the people who wish to purchase that product in that country.
• For example, if product X is shipped from Florida to Canada, the normal cost for a Canadian to buy that product may be $10. If a 20% tax is applied to that product when it enters Canada, the cost to the Canadian buyer is now $12. If there are other similar products available, but at a lower price, the Canadian buyer is more likely to buy that other similar product for $10 rather than spend more on the first product.
• What are the pros and cons to this type of activity? On the one hand, this is one way for a government to help local businesses compete better against larger businesses who are importing their lower cost goods from abroad. But on the other hand, if the local consumer has little choice, then they are forced to pay a higher amount of money for this product, whether they like it or not.
• Now, this last point is really important because when the prices of products are pushed higher due to these tariffs, this can be “inflationary”, meaning that the costs of everything start to go up. For example, when the US applies tariffs to imported steel, the higher cost of imported steel makes US steel manufacturing that much more competitive. This is good for US steel related jobs, or is it? As a result of this higher cost of steel, all related products that come from steel now also cost more as well: cars, refrigerators, construction, and so on. For consumers and businesses to afford these higher costs, businesses have to charge higher prices. For consumers to afford these higher prices, their wages have to go up. This is inflation, when the costs of everything begin to rise.
• The negative outcome of higher inflation is also higher interest rates. To keep the rate of inflation at a target level of 1.5% to 3%, the central bank is responsible for raising interest rates when the rate of inflation begins to move to these higher levels. The challenge for the central bank, however, is that it is not as simple as just raising interest rates one or two times. Instead, inflation can quickly compound out of control, such as what we saw in the last half of the 1970’s. Therefore, the role of the central bank is to be proactive and to raise interest rates gradually over time so that inflation never gets out of hand.

So what does all of this mean to you, me and the markets?

• A growing economy is one thing, whereas a trade war is something unto itself.
• The central banks can increase interest rates gradually when the economy continues to grow but when a trade war develops the increased risk is that inflation appears more quickly and more harshly, thus forcing central banks to increase interest rates more quickly.
• What’s the trickle down effect? This means that the interest rate on your mortgage may go up in the months ahead because President Trump implemented steel tariffs on Canadian steel imports into the United States. If interest rates have to go up quickly, then this will cause a more negative impact on the prices of stocks in your portfolio.
• But there are some exceptions to this. Historically, “hard assets”, such as energy, materials and real estate can increase in value during an inflationary environment.

And this is where it gets really interesting: is the increase in the energy, materials and real estate sectors these past few months more indicative of an inflationary trend instead of a healthy, growing economy?

That is now the key question facing investors today. I appreciate that this can be quite complex, so if you have any questions about this, please send me your thoughts.

Since the last report, what has happened with the NFC Tactical Asset Allocation Pool?

• As mentioned previously in Table 2 and Table 3, sample conservative, balanced and growth portfolios have generated some modest returns.
• By comparison, since the last report, the NFC Tactical Asset Allocation pool has increase in value by 1.9% for a 12 month return of +4.55% net of fees. By comparison the Toronto Stock Exchange Price Index has increased by 5.92% over the past three months and 7.22% for the year.
• In general, we talk about striving to capture 70% of the upside of the market while protecting against 70% of the downside of the market over time.
• With this in mind, 70% of the TSX price index return year to date is +0.29% (70% X +0.42% = +0.29%) vs. the pool return is +2.70%. So far this year the pool has well exceeded this comparison.
• 70% of the TSX price index over the past 12 months is +5.05% (70% X 7.22% = 5.05%) vs. the pool return of +4.55%. For this 12-month period the pool did not capture 70% of the upside of the market.

What Have We Been Up to Over the Past Several Months?

In the March 30, 2018 commentary I wrote the following:

Over the past several months Mike and I have reviewed, discussed and pursued three themes:

• Theme #1: We do believe that the global economy is growing and we also believe it is prudent to continue to have an overweight position in equities (stocks). With the recent correction of the market over the past 3 months, we believe this makes the stock market less risky today and stock prices less expensive than what we saw late this past fall. Therefore, I have been topping up our current equity holdings as prices are lower than they have been in the recent past.

We continue to watch for lower risk investment opportunities. We have also been seeing a great number of individual securities start to spike. This is typically an indication that the upward momentum of the stock may be coming to an end, which is an indication that we should be potentially trimming the profit in these positions. We have more “trim” orders in place today than we have had in a while.

• Theme #2: With this growing economy and rising interest rates, we do feel that there is increasing risks of inflation. In this type of environment commodities can do well; which means I have continued to reduce exposure to interest sensitive investments, such as telecommunications companies and utilities, and increase exposure to energy, gold and materials.

We see the positive impact of my increased exposure in these areas when we compare the returns of the NFC Tactical Asset Allocation Pool with the other sample portfolios (Table 2, Table 3).

• Theme #3: Reduce Canadian exposure and increase global exposure. We do not feel that the current economic environment in Canada is as good as other areas of the world. Therefore, I continue to add to our global holdings and reduce our Canadian holdings.

We continue to hold this view. We do not believe the growth in the Canadian stock market index is indicative of Canadian economic growth, but rather a response to potential inflationary pressures.

What changes have been made to the NFC Tactical Asset Allocation Pool?

• Table 4 below illustrates the changes to the overall asset mix of the pool over the past 2 years. Note that the pool remains growth oriented with the growth component continuing to be in the 55% to 60% range.
• Table 4 also illustrates the geographic weighting. With the changes made in April, I am continuing to tilt toward U.S. and Global Exposure. We are at the highest level of US and International exposure than we have been in the past.

Table 4: NFC Tactical Asset Allocation Pool: Asset Mix for the period ending as displayed. Source: Croesus Software.

 

Where Do We Go From Here?

One of my greater concerns today has to do with interest rates, inflation and something called the yield curve. The yield curve is a chart that shows a comparison between interest rates over different periods of time. The yield curve is currently “flattening” which is often an indication that a recession is ahead.
More specifically, the gap between the 2-year interest rate in the US and the 10-year interest rate in the US is now only 0.27%. This means that you would earn only 0.27% more interest per year invested in a 10-year US government treasury bond than you would in a 2-year US government treasury bond. Going back to 2014, this gap was closer to 2.60%. Since 2014 the yield curve has become increasingly flat, as the gap between the short-term rate and the long-term rate continues to narrow.

Table 5: The Difference Between The 10-Year US Government Treasury BondYield and the 2-Year US Government Treasury Bond Yield. Source: YCharts.

This is concerning because the US Federal Reserve (their central bank) has stated that they expect to increase the short-term interest rate by as much as 0.50% over the next 6 months, based on where they see both economic growth and inflation today.

By increasing the rate this much, the spread between the short-term rate and the long-term rate may then be potentially negative. This means that an investor would earn more by investing into a bond that matures in 2 years instead of one that matures in 10 years. This means that the yield curve is now inverted, which is typically a predictor of a future recession. For example, consider this article on Investopedia.com
(https://www.investopedia.com/terms/i/invertedyieldcurve.asp).

It is interesting to note that the last two times we saw an inverted yield curve in the US were (are you ready for this): i) March 2000: just as the market began a 47% correction in the S&P 500 index that lasted over 3 years (March 11, 2000 to March 3, 2003) (source: YCharts) and ii) January 2007: the S&P 500 index in the US peaked in October 2007, leading to a 56% correction in the market that lasted 17 months (October 1, 2007 to March 9, 2009).

So, what does this mean?

• This means that Mr. Trump’s trade war may lead to higher interest rates more quickly.
• This means that we may see an inverted yield curve by the end of 2018.
• This means that we could see the beginning of a prolonged market correction beginning any time in the next 12 months.

Therefore, I am managing the portfolios with these thoughts in mind, mindful of the risks and opportunities that this can bring.

If you have any questions or concerns about your personal portfolio, please let me know. I would be happy to meet with you at any time.

All the best!

Doug

Announcements:

Welcome Aboard Nicole Ross! Nicole is the newest full-time addition to our team, taking over duties from Lorraine Goldring. Nicole joined our team in mid-May, and is responsible for all portfolio administration and client service initiatives. Nicole comes to Nelson Portfolio Management Corp. with over 15 years of related banking and customer service experience. We are very pleased to have Nicole join our team.

With Nicole’s addition to the team, this additional support helps Lynda Perrick, Portfolio Services Specialist, continue to develop her portfolio analysis expertise through Doug’s guidance. Lynda is studying for her Canadian Investment Manager designation, which will help her qualify to become an Associate Portfolio Manager.

Nicole will also help NPMC expand some of its customer service initiatives, helping us to be in contact with you more frequently and addressing your administrative questions in a more timely manner. Please check out Nicole’s profile on our website.

Nicole is available to help quarterback your administrative requests while also helping you get in touch with the right person on our team.

Welcome Aboard Henry Letkeman! Henry is also a new addition to our team, taking over duties from Anne Gendzelevich. Anne joined our team in the fall of 2016 on a part-time basis as our business bookkeeper and to assist with the oversight of several internal policies and procedures. Anne and her husband are beginning to phase into their retirement plans, which gave us the opportunity to transition this to a full-time role. Henry is a CPA – CMA who will assist Doug in the day-to-day operations of Nelson Portfolio Management Corp., including areas such as bookkeeping, financial management and compliance. As Nelson Portfolio Management Corp. continues to grow, we continue to expand many of our core roles and are excited to welcome Henry to the team. Henry has 30 years of small business advisory experience.

Secure Quarterly Statements: Version 2.0: We are now sending to you your quarterly portfolio statements in a slightly different manner. We have set up for each client family a secure and encrypted file folder using the Microsoft One Drive. In this folder, all historical portfolio statements will be stored. In this way, should you wish to access previous portfolio statements, you may do so at any time. As a second level of security, your report will now contain a password. The password will be the year of birth of the older spouse. As a third level of security, the report will not be sent as an attachment to your email. Instead, you will be sent a link to your unique folder once your statement is ready for viewing. Finally, as a fourth level of security, we will be able to retain records the extent to which you are viewing your statements. This will help us ensure that we are providing to you the information you wish in the way you most wish to receive it. Our objective is to continually explore ways to provide to you meaningful and timely statements, in a safe and secure manner. Please send us your feedback on this new, enhanced approach.

Discrepancies between the Nelson portfolio reports and the NBIN (National Bank Independent Network) monthly statements: We see that in some cases there are some small discrepancies between the total portfolio value seen on the Nelson statements and the NBIN monthly statements. In most situations these discrepancies are caused by the timing of when the NBIN statements are produced and when the data concerning the quarterly distribution for the NFC Tactical Asset Allocation Pool is provided to NBCN. This is a timing issue and not an error. Should you have any questions or concerns, or if you identify other discrepancies, please let us know immediately.

Paper vs. Secure E-Mail Link: It is NPMC’s preference to provide to you this quarterly portfolio package by e-mail. However, if you would like to receive this package in paper format, please let us know and we will accommodate your preference accordingly.