The following commentary represents the opinions and analysis of Doug Nelson, President, Portfolio Manager, Nelson Portfolio Management Corp. as at July 4, 2019.  Market and index returns noted below are based on the price changes for each quoted item for the period ending June 30th, 2019.  Market Statistics:  Source: https://ycharts.com.

• Over the past 3 months the Toronto Stock Exchange Composite Index (TSX) increased in value by approximately +0.95% from April 1, 2019 through to June 30th, 2019. Over the past three months the returns have been mostly sideways (See Chart 1).
• From April 1st through to June 3^rd the return for the quarter was showing -1.31%. Thus, all of the gains for the past three months have taken place over the past three weeks.  Since June 3^rd the TSX has gained in value by +2.26% based on the hope and expectation that the Federal Reserve in the United States will cut interest rates in July 2019.  The market hopes that interest rates are cut so that the growth cycle in stocks will continue.  In other words, some believe that interest rates are too high relative to the economic environment today.  The economic data is suggesting that the global economy is slowing (which can be expected given the trade and tariff wars between the U.S. and mostly every other region in the world)), therefore the U.S. Federal Reserve should lower interest rates.  It is this hope or expectation that has moved markets higher these past few weeks.
• Over the past 12 months the returns for the S&P TSX Composite Index have been mostly flat, showing a gain of +0.64% on the index since July 1, 2018. However, this flat return endured significant volatility where we saw a -16.82% decline from July 7, 2018 through to December 24^th, 2018 and then a corresponding rebound of +21% from December 24^th through to April 23^rd.  Since April 23^rd the Toronto Stock Exchange Composite index has declined by another -1.72%.  Yes, to end up with a flat return over the past 12 months we experienced some wild swings in the market.

Chart 1:  The Last 12 Months:  S&P TSX Composite Index from July 1, 2018 through to June 30th, 2019.  Source: https://ycharts.com

In the chart below, please note the following observations:

• The S&P TSX Composite Index (the Toronto Stock Exchange) declined by -1.26% during the summer of 2018, then declined a further -11.10% during the fall of 2018.
• These amounts were recovered by the market through the January 1st to March 30^th, 2019 time period where we saw a positive return of +12.42%.
• But since then returns have been sideways to negative, with the exception being the past three weeks.

Now let’s look at the performance of other regions and sectors over the past 4 quarters.

Table 1:  Asset Class, Region and Sector Returns Over Past 4 Quarters.  Source:  https://ycharts.com

In Table 1 above we observe the following points and we begin by looking at those items in the Defensive category:

• The first column above shows the returns of various regions and sectors over the past three months. As interest rates have declined, due to market concerns over a softening economic picture, the price of bonds have gone up.  This is why we see some positive gains in the Canadian Bond Index (XBB at +2.30%) and US Investment Grade Corporate Bonds (XIG at +4.62%).  Over half of the investment returns in these areas over the past year have occurred in just the last three months.  It is also interesting to see how these same bond indexes have outperformed the Canadian Stock Market (TSX at +0.95%), the U.S. Market (S&P 500 at +2.60%) and the European / Asian index (EFA at +0.06%).
• In the next two columns we see the declines that took place in the fall of 2018 and the recovery in the winter months of 2019.
• In the far-right column we see the 12 month returns ending June 30^th, 2019. It is interesting to see that the bond indexes have done well over this time (XBB at +4.23%; XIG at +7.26%) but offsetting this is the decline we see in the preferred share basket (XPF at -8.61%).  Our portfolios typically have a 4% to 7% weight in the preferred share category, so this is one area that negatively impacted our portfolio returns over this past year but sets us up well for potential gains in the year ahead.  We saw similar declines in the preferred shares in 2013 (-6.84%) with a reasonable gain in 2014 (+5.00%).
• Looking at the defensive category overall, if you had an equal amount of your defensive holdings in each of these four areas (XBB, XIG, XPF, XHY) over the past 12 months, your average 12-month return would be only approximately +1.10%.

Now let’s take a look at the Growth markets and sectors:

• Over the past three months the best performing sector was gold with a three month gain of +9.6%. We have always held a position in gold and have recently begun to add to it.  The 12 -month return for gold is approximately +12.26%, which was also the top performing sector for this time period.  Again, it is interesting to note that with the decline in the interest rate on bonds, a corresponding rise in the price of bonds as well as a rise in the price of gold, these are all potential signals of a slowing economy and money moving into more defensive areas.
• The worst performing sector was energy, with a 3-month decline of -10.7% and a 12-month decline of -31.96%. This is a great representation of just how significantly one of Canada’s most important economic engines has been impacted.
• What’s the ripple effect of this? When we see a softening economy that is greatly impacted by the slow down in the energy sector, then we also see interest rates fall, which then impacts the profits of the banking sector.  The three-month return of the financial services index in Canada is only +0.95% and the 12-month return is only +1.26%.
• These issues then have an impact on investor returns, where we see the 12-month return of the Toronto Stock Exchange Composite index to be only +0.64% for the past 12 months.
• For Europe / Asia we see a 12-month return of -1.85% and the Emerging Markets at -2.13%.
• Looking at the U.S. market, everything on the surface appears to be okay (but it may not be as you will see shortly). The 12-month return for the S&P 500 index (the 500 largest companies in the U.S.) posted a gain of +8.22%, with much of the gains generated by health care and technology.
• But when we look more deeply, we see that the U.S. market continues to be dominated by just a handful of largest technology companies. For example; if we look at the more broad based New York Stock Exchange Index (which is an index of close to 3000 companies vs. the S&P 500 index of 500 companies), the 12-month return was only +4.36% (close to half the return of the S&P 500 index).  Now let’s look at both mid-sized U.S. firms (12-month return of -1.62%, symbol XMC) and small U.S. firms (12-month return of -6.84%, symbol XSU).  These figures can hint to us that again the U.S. market indexes are being greatly influenced by just a handful of very large technology companies such as Apple (+6.92%), Microsoft (+35.85%) and Amazon (+11.4%) where large sections of the U.S. market have actually declined in value (mid-size companies: -1.62%, small sized companies: -6.84%).  If an economy is doing well, it is usually the small to mid-sized firms that out pace the growth of the large sized firms, but this is not happening.
• The problem with this concentration risk in the large technology names is once investors start to turn their attention away from these companies, the market can be pushed down further and faster than what it otherwise should.

So, what can we conclude from all of this?  Does the market have strength or is it potentially setting up for another decline over the summer?

One sector to look at to help answer this question is the transportation sector in the U.S.  If people and goods are moving, then typically the transportation sector is performing well.  Thus, the transportation sector is often referred to as a “leading indicator” of the economy.  When goods and people are moving, then the economy is doing well.  When people and goods are not moving, then the economy may be heading for a slow-down.  Here is the 12-month chart of the transportation index in the U.S. today.

Chart 2:  Transportation Index (symbol IYT) in the U.S. over the past 12 months ending June 30^th, 2019.  Source:  https://ycharts.com

In the chart below we see the following:

• Since the peak in September 2018, the transportation index has declined by -9.73%. The 12-month return for this sector is only +1.0%.
• By comparison, the S&P 500 index shows a slight positive return of +0.38% for this same period of time.

This raises a couple of interesting questions:

• If people and goods aren’t moving as shown by the decline in profits of most transportation-oriented companies, then how is it that the overall market index is out pacing the transportation index by almost 10%?
• If the small and mid-sized companies have declined over the past year (-6.84% and -1.62% respectively) and the transportation index has also had a below average return of +1.0%, then we can see that the only sector that continues the drive the market is technology.

Concluding Observations:  Markets have been quite volatile over this past year.  Depending on the investment holdings and the time period selected, investment returns could have looked awful (if you were over concentrated in energy stocks for example) or quite good (if you were over concentrated in technology stocks).  Yet overall market returns have been mostly sideways over the past year, but we are potentially seeing signs of continued weakness.  If the Federal Reserve does cut interest rates this summer, will we see the market begin to move higher or will the continued trade and tariff war (Trump vs. the world) cause the global economy to continue to slow, thus resulting in a market decline?

In this environment how has the NFC Tactical Asset Allocation Pool Performed?

Since the NFC Tactical Asset Allocation Pool represents a significant component of your portfolio, and since the pool represents our core investment strategies, discussing the returns of the pool gives you a good representation of how your portfolio has been managed during these periods of time.  All performance figures are reported to you after all fees and expenses.

• The 12-month return for the NFC Tactical Asset Allocation pool is +1.37%. From an overall rate of return perspective, this is not a number that we can get too excited about.  However, to put this into context, please consider the following points:
• For the period ending June 30^th, 2019, the return on the NFC Tactical Asset Allocation Pool (+1.37%) is more than double the return than the Toronto Stock Exchange (+0.64%).
• Year to date: from January 1^st to June 30^th, the NFC Tactical Pool has gained a positive return of +5.4%.
• Over the past 3 years, 5 years and since inception, the NFC Tactical Asset Allocation Pool has generated the following returns: (outperforming the S&P TSX Composite Index over time.)

Table 4:  Historical Annual Compounded Rates of Return:  NFC Tactical Asset Allocation Pool and the S&P TSX Composite Index for the Period Ending June 30^th, 2019.

Source: Croesus (NFC TAA) and https://ycharts.com (S&P TSX Composite)

NFC Tactical Asset Allocation Pool Inception Date: September 3, 2013

• The out-performance to the TSX is linked to several key items: i) our exposure to the U.S. markets, ii) a focus on generating a 3% to 4% overall yield (interest and dividend income) in the pool and iii) an active risk management strategy which has helped to protect against larger declines.

Therefore, while the 12-month return at this time is nothing to get too excited about, historically we see that our approach has generated some very favourable outcomes.  This gives us the confidence to continue to follow the same strategies into the weeks, months and years ahead.

What Have We Been Up To?

We have been active in several important areas over these past few months:

• Romspen Mortgage Investment Fund (symbol: RIC101) (romspen.com):  This is a new core holding in the NFC Tactical Pool as well as in most client accounts.  Based out of Toronto and funding mortgages of commercial and industrial projects across North America, the pool is close to $3 billion in size with a 25-year track record.  The volatility in the pool has been low because of the short-term nature of the mortgage / construction loans, while generating a return of 6% to 8% annually.  This is similar to the Frontenac Mortgage Investment Corp. holding that we have held for the past several years (stable valuation, consistent 5% to 6% yield).  While Frontenac funds the construction loans of individual homes in rural Ontario, Romspen funds construction loans of major commercial and industrial projects across North America.  Based on this history, we expect this holding to help lower the risk profile of your portfolio while providing a consistent return of 6% to 8% annually.
• Plant Based Protein: With the IPO of Beyond Meat (symbol BYND) and the addition of plant-based protein products at most fast food outlets today, the growth in this area may be considerable in the years to come.  One school of thought today is that much of the feed provided to animals that are then used for human consumption is leading to increased health issues for humans as they age.  Alternatively, the argument is that plant-based proteins may provide the protein we need to be healthy, but without the negative side-effects.  To participate in this growth, we i) invested into the IPO of Beyond Meat and have since generated a profit 125% and ii) we have also added small positions of Maple Leaf Foods (in Canada) and Tyson Foods (in the US) to also potentially participate in this area.
• Gold: The recent price high for Gold dates back to July 2016 and again in January 2018.  This level was not surpassed until June 18^th, 2019.  This may mean that we are in a new uptrend for Gold, which would be consistent with a weakening global economy and falling interest rates.  As a result, we increased our weight in gold.
• International Exposure: We continue to expand our non-Canadian exposure.  In December we sat at 29% outside of Canada whereas today we have 31% invested internationally.  We continue to look for emerging growth opportunities, with minimal downside risk and a reasonable yield.

Where Do We Go from Here?

I believe in the sand pile theory of investing.  Each new piece of news is like one additional piece of sand that drops on pile of sand.  As more news becomes available this can impact the sand pile, resulting in the continued growth of the sand pile or an outcome where the pile begins to collapse.  When the pile collapses, this is analogous to a market correction.

The three biggest pieces of news today, in my opinion, are as follows:

• The flattening of the yield curve in the U.S.: While the interest rate of the 10-year U.S. government bond (1.96%) remains only 0.2% higher than the 2-year government bond (1.76%), the small differential may still be suggesting that a recession is near.  We continue to watch this trend.
• The U.S. China Trade Agreement: My personal opinion is that a new trade agreement is unlikely and may further divide the world between east and west.  This may then have a very negative impact on global trade and global economic growth.
• Interest Rates: Is the economy slowing to a point where the U.S. Federal Reserve will lower interest rates in July (or in the coming months) and will this be seen as a positive for U.S. stock market growth?  This is an ironic statement to make because if the economy isn’t doing well, then why would stocks be increasing in value?  An interest rate cut may extend the growth in stocks, but perhaps only temporarily.

Depending on how these events unfold, the stock markets in Canada and around the world will react accordingly at those times.

Therefore, at this time my preference is to:

• Remain in a neutral balanced stance,
• Where we are well diversified globally,
• We invest in securities that appear to be gaining upside growth momentum,
• We trim securities that appear to be losing momentum,
• And we strive to create an annual yield of 3% to 4%.

If you would like to get together for a personal portfolio review, please let me know.

All the best!

Doug

Announcements:

• Lynda Perrick, Associate Advising Representative: Please join me in congratulating Lynda on being registered with the Manitoba Securities Commission as an Associate Advising Representative.  Upon completion of her Chartered Investment Manager designation this past fall, and meeting the relative work experience requirement, Lynda is now in her apprentice period to be registered in the future as a Portfolio Manager.  Lynda has worked very hard to achieve this milestone and we are very happy for all of her success so far.  Lynda will continue to play an increasing role in meeting with clients to perform portfolio reviews, she is involved in doing ongoing suitability reviews of all client portfolios and is a member of the investment committee responsible for the management of the NFC Tactical Asset Allocation Pool.
• Book Value vs. Market Value On Your National Bank statements: The book value information on your National Bank statement is not your net invested value.   Rather, the book value is the total of your invested value minus withdrawals and plus any dividend income received.  Thus, part of your investment return over time will show up as part of your book value.  Therefore, please do not compare the book value and market value on your National Bank statements and believe that the difference is your investment return.
• 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.