Quarterly Market Commentary

The following commentary represents the opinions and analysis of Doug Nelson, President, Portfolio Manager, Nelson Portfolio Management Corp. as at April 12, 2018. Market and index returns noted below are based on the price changes for each quoted item for the period ending March 31, 2018. Market Statistics: Source: https://ca.finance.yahoo.com, https://ycharts.com

• The Toronto Stock Exchange had a quick start to the year posting a +1% gain between January 1
  through to January 23rd. Since then the return on the Canadian index has been -6%. The bulk of this
  decline took place between January 23rd and February 9th. Since February 9th the market has gained
  in value by 2.09%. Putting all of this together, the return for the past three months was a total of -5.1%.
  All the market gains since last September have now been erased. The 12 month return since last April 1
  now show as -0.93%
• 
• All the major sectors in the Canadian market over the past three months posted negative returns:
  Financials (XFN, -4.17%), Energy (XEG, -7.91%) and Materials (XMA, -4.64%). The better performing
  sectors were Real Estate (XRE, +0%) and information technology (XIT, +9.83%).
• Many of the defensive holdings in the market also declined these past three months: US Investment
  Grade Corporate Bonds (XIG, -3.97%), US High Yield Bonds (XHY, -3.73%) and North American
  Preferred Shares (XPF, -1.73%).

So why did the markets decline like this?

• 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.
• So here’s the great irony to all of this: if the economy is doing well, why aren’t stocks going up? More on this later.

Let’s now look at the U.S. and International Markets:

• Over the past three months the S&P 500 (the 500 largest companies in the United States) declined by -1.4%.
• The worst performing sectors in the U.S. market were: Health care (IYH, -0.93%), US Banks (IYF, -1.36%), Utilities (IDU, -4.08%), Energy (IYE, -6.76%), Industrials (IYJ, -1.6%), Consumer Goods (IYK, -6.17%), Materials (IYM, -5.99%), Real Estate (IYR, -6.84%), Transportation (IYT, -2.4%), Telecommunication (IYZ, -8.13%).
• Of the major U.S. sectors, the lone sector that saw an increase in value was the technology index (IYW, +3.34%).
• Outside of North America we see similar outcomes: Europe / Asia / Far East (EFA, -0.90%). But in the emerging markets we see a different story of +5.05% (XEM). Global industrials (XGI) generated a 3 month return of -3.06%.
• We see that the U.S. market these past three months performed similar to Canada, where much of the market posted negative returns in the first three months of the year.
• While the Canadian market declined by -5.78%, the US market by -2.04% and Europe / Asia -0.90%, the NFC Tactical Asset Allocation Pool declined by only -0.68%.

The U.S. market has also posted some negative returns, 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.

But before we go there, here’s the updated chart of historical performance of our commonly held exchange traded funds and the market indexes.

Table 1: Historical Returns for Winter 2018 (January 1 to March 31, 2018) vs. Spring 2017 (April 1 to June 23, 2017) vs. Summer 2017 (June 24 to September 29th, 2017) vs. Fall 2017 (September 30th to December 31st, 2017) vs. the Last 12 Months (April 1, 2017 to March 31, 2018). Market Returns Source: ca.finance.yahoo.com. NFC Tactical Asset Allocation Pool source: Croesus software. The industry standard rate of return disclosure of 3, 6, 9 and 12 months is illustrated on your client specific investment statement. The time periods selected for the tables in this report were chosen to illustrate recent changes in the markets with different types of investments.

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

• Since the last report, the NFC Tactical Asset Allocation pool has decreased in value by -0.68% for a 12 month return of +2.94% net of fees. By comparison the Toronto Stock Exchange Price Index has decreased by -5.78% over the past three months and -0.93% 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 over the past 12 months is -0.65% (70% X -0.93% = -0.65%) vs. the pool return of +2.94%. The pool has done well over the past 12 months relative to this measure.
• Fundata Analysis (December 2017): In January we received from Fundata (www.fundata.com) the December detailed analysis report on the pool. At that time, for the 3 years ending December 31, 2017, the pool had the 30th highest return and the 16th lowest level of volatility, measured against 146 other Neutral Balanced Funds available to Canadian investors in Canada. We receive this report on a quarterly basis. This means that the pool was ranked in the top 20% of this peer class over the past 3 years. We are very proud of these very significant results, both in terms of investment return but also risk management. If you would like a copy of this report please let me know.
• Fundata Analysis (March 31, 2018): We have now received the same Fundata analysis report on the pool for the period ending March 31st, 2018. Over the past three months the NFC Tactical Asset Allocation Pool was ranked as the 35th highest returning fund of the 165 comparable funds in the Neutral Balanced category for this time period. This is in the top 22% of this group.
• In January the cash weighting in the pool was 12.5%. With the market decline in late January and early February, half of this cash has been invested. The current cash position of the pool is now 6%.
• This cash was invested because of the belief that this correction helped to reduce the risk profile of the market (such as what we talked about in the last commentary) and of the belief that the U.S. and global economies ARE moving in the right direction. Note that we DO NOT believe that the Canadian economy is moving in the right direction and so we have decided to continue to reduce our exposure to Canadian equities. More on this in the next section.
• As I mentioned in the last commentary, one of the main concerns appears to be our ability to get one of our most valuable resources (Oil) to other markets around the world. Over the past few years several pipeline projects have been cancelled for various reasons. Most recently, the twinning of the current Trans-Mountain Pipeline has been stalled by the B.C. government, even after the pipeline passed all the environmental assessment processes and gained approval from the Federal Government. This additional delay puts into question the relevancy of our environmental assessment process if after all this time and studies, the pipeline can still be blocked. But from a bigger picture perspective, this sends a message to the international community that Canada is a difficult place to invest and do business. As a result, the spread in the price between West Texas Intermediate (WTI) and Alberta Crude, continues to widen. Since January 1 this spread has increased by another 5%, which is very significant and is not a positive development for the Canadian energy industry. http://economicdashboard.alberta.ca/OilPrice
• The other interesting ripple effect on this relates to the railways. If the railways continue to spend most of their time transporting oil (instead of having oil move through the pipelines), then this continues to restrict the ability for those same railways to move our farm crops to global markets, which in turn can have a negative impact on this sector of our economy as well.
• It is our view that these situations have caused a negative impact in Canadian equity markets, which has then influenced our investment decisions.
• Please note: when I refer to us and we above and below, I am referring to Mike and I, as we both review and discuss the markets, the economy and investment strategy. Once this discussion is complete, I am then responsible for making all of the final portfolio decisions.

What Have We Been Up To Over The Past Several Months?

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.
• 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.
• 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.
  What changes have been made to the NFC Tactical Asset Allocation Pool?
• Table 2 below illustrates the changes to the overall asset mix of the pool over the past 2 years. Note that the pool is more growth oriented today than it was in December (42% defensive today vs. 47% defensive in December 2017).
• Table 2 also illustrates the geographic weighting. With the changes made in April, I am continuing to tilt toward U.S. and Global Exposure.

Table 2: NFC Tactical Asset Allocation Pool: Asset Mix for the period ending as displayed. Source: Croesus Software.

Where Do We Go From Here?

In the September 2017 report I wrote: “Today the markets look to be strong with many positive trends in place. This is good! The summer months were quite typical in that little to no gains were achieved until approximately 2 weeks ago. So after a summer of zero returns, it makes sense that we would begin to see some growth. Combining this with the hope that U.S. tax reform is positive for the markets and we could see markets continuing to rise from here.” This is exactly what we have seen.

In the December 2017 report I also wrote: “Alternatively, it is hard to ignore the current valuation levels and other external, unpredictable areas such as the rising uncertainty relating to North Korea. If we ignore North Korea, we may do very well if markets continue to rise. Alternatively, with the high market valuations in place, if there is an unexpected event could we see a 10% to 20% market correction come quickly?” This is still a risk we need to consider.

With these thoughts in mind, from late January to the end of March, the Canadian equity market price index dropped by almost 8% (from peak to trough) while the S&P 500 index in the U.S. dropped by almost 10%.

Is this correction now over?

This has yet to be confirmed, but every day passes and the markets move higher, the resolve to move the market higher will likely grow.

Just as we saw in the fall with North Korea, the U.S. president continues to be in the news on a daily basis on a wide range of subjects. From time to time the comments from this President do tend to create some uncertainties in the market. We do expect to see some volatility in this market over the coming months.

If the Toronto Stock Exchange price index in Canada were to move below the 15,000 level (currently at 15,305) and if the S&P 500 price index in the U.S. moves below the 2,575 level (currently at 2,660), then we could see the markets lose another 6% to 10% of its value.

In the last report I mentioned that most of the growth in the market this past fall had come from the technology stocks. I am quite pleased to see that since the beginning of the year it has been the small and mid-sized companies that have created most of the growth. This gives me some confidence that the strength of the market is widening.

So what’s the best approach in a time like this?

It appears to me that the corrections we have seen so far this year have helped to reduce the risk profile of the market, but we could still see some further downside? I believe that the trend at this time continues to be upward moving, but that we need to turn our attention to global growth and the risks of inflation.

Currently, we continue to have a balanced approach that is tilted towards growth. I continue to hold our growth oriented positions, but I have also a) reduced our cash holdings, b) increased our equity weights and c) I am beginning to increase our global exposure.

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