Monthly Commentaries
It’s Not You, It’s Me | February 2018
“People change and forget to tell each other.”
Lillian Hellman
Ask any couple that has been together for a while, and they will tell you that relationships change. They go through phases, have their ups and downs, and experience shifts in dynamics. Through her neuroimaging research, Dr. Helen Fisher has even shown how our brain’s chemistry evolves through the various stages of love, from the intensity of initial attraction to the deeper bonds of attachment.
As far as relationships go, the star couple of most investment portfolios, the ‘Brangelina’ if you will, are bonds and equities or ‘Bequities.’ While they lack the glitz and glamour of Brad and Angelina, their relationship is a key driver of portfolio returns and should be central to asset allocation decisions. The trouble is, as with so many famous couples, theirs is a turbulent and often unpredictable affair, at times pulling in opposite directions and at others moving in tandem.
Last month, both partners made headlines as a rise in yields not only took fixed income lower but precipitated a sharp sell-off in equities. This was not only painful for investors but raised questions on the interplay between the two asset classes.
Over the past two decades, the expectation has been that fixed income would provide at least a partial offset to losses from equities. The assumption being that meddling on the part of central banks would prop up securities, in what became known as the ‘Fed Put.’ This has certainly been the case since 2009, with lower interest rates and monetary stimulus creating a honeymoon period with strong performance across risk assets. But it now appears that investors need to realize that the central bankers are ‘just not that into you,’ and that the correlation between stocks and bonds could be changing.
In trying to understand the dynamics of romantic relationships, the psychologist Robert Sternberg developed a triangular theory of love with the three components being intimacy, passion, and commitment. When it comes to the relationship between stocks and bonds, economists see the key drivers being valuations, inflation, unemployment, growth, and the level of interest rates.
Taking valuations as a starting point, there are concerns around the expensiveness of stocks, and given the low to rising yield environment, it is difficult to see much value in fixed income. Although it is far too early to call for ‘inflationary times,’ with unemployment near historic lows, strong global growth, and the potential for trade wars putting upward pressure on prices, there is the possibility that inflation surpasses current forecasts. All of this combines to create a difficult environment for the traditional beta portfolio.
So after almost a decade of being the investors’ darlings, with both of them performing well, the outlook for ‘Bequities’ isn’t so rosy. The return expectation for fixed income is flat to small negative, with the risk being that rates rise faster and higher than anticipated, turning the small negative into a large one. If this does happen, there is potential that an already jittery stock market follows suit on the downward path. Perhaps then it is time for this couple to consider following ‘Brangelina’ and start dating other asset classes.
The Fund
The markets seemed intent on solidifying February’s reputation as a miserable month. Credit gave back January’s performance and then some, with spreads widening 5 to 25 bps on the month. The recent outperformers such as bank subordinated debt (NVCC) and REITs were particularly hard hit. Generically, spreads are 2 to 3 bps wider YTD in Canada, and roughly 7 bps wider YTD in the US.
The initial damage resulted from the dramatic drop in equities, although when stocks recovered and stabilized (sort of), credit continued to leak wider under the weight of new supply. Despite the poor tone, issuers (perhaps concerned about rising rates) sold $9.6B in the primary market (2nd highest February issuance in history), with the vast majority coming at the tail end of the month. This led to the market being overfed in a short period of time, particularly as US bond funds/ETFs experienced large redemptions, forcing managers to liquidate holdings. We don’t believe Canadian managers are experiencing significant redemptions. However, the situation south of the border kept some people on the sidelines. The dynamic in the marketplace meant there was no place to hide, as even normally ‘safe’ short maturity bonds were pressured wider as well.
After January’s solid rally in credit, we had trimmed longer maturity positions preferring to concentrate in the two-year and under space. Throughout February we used pockets of liquidity to reduce risk further and add to hedging positions. Although we did not give back all of January’s gains, the fund was down 45bps this month.
| Year | YTD | |
|---|---|---|
| 2018 | (0.45%) | 0.74% |
| 2017 | 1.30% | 8.46% |
| 2016 | 1.49% | 23.15% |
| 2015 | 2.29% | 15.86% |
Credit
Given the turmoil in the markets, any forward-looking views should be taken with a grain of salt, and we remain prepared to adapt to changing situations. Accordingly, we continue to maintain a more defensive and flexible posture but are mindful that volatility can create some interesting opportunities. With that in mind, there are a few particular developments that we are watching closely.
One of which is how well the flood of M&A related new issuance from CVS and Choice REIT is digested. Also, high on our radar are the inflows and outflows from bond funds and ETFs, which will determine the buying or selling pressure exerted by traditional asset managers. Furthermore, with the rise in interest rates the all-in yields of the 5y space have become particularly attractive, therefore, we are monitoring further term extension from the long only crowd, as they move from shorter to longer-dated securities.
As always, one eye must be kept on the chaos within the White House as protectionist threats at month-end led to another risk-off move. With equities already in a fragile state, we are hopeful to get a more rational direction in trade policy from the U.S. administration but remain cautious of the headline risk that can come from 4 am tweets.
Despite the negativity pervading the markets, higher credit spreads do not seem to be attributed to fears that a recession is looming. Instead, it appears that investors are reassessing valuations and are struggling to digest a deluge of issuance. The silver lining is that widening episodes set the conditions for better prospective returns either because carry improves or spreads narrow.
Rates
The big picture view remains the same. Global growth remains strong enough to prompt central banks to move away from monetary stimulus. The risk is that US yields move higher than most people expect. Fortunately, Canadian rates shouldn’t move as much. A potential creeping trade war with our largest trading partner, high personal debt levels, and an uncertain housing market will likely temper the Bank of Canada’s enthusiasm to pursue multiple rate hikes this year. The Federal Reserve will likely deliver three or four more hikes in 2018, while the Bank of Canada might just have one more left to do.
Regards,
The Algonquin Team
Econophysics 101 | January 2018
“Gravity wants to bring me down.”
John Mayer
Since the Great Recession of 2008, interest rates, like early aviators, have had to contend with the power of gravity. But while the Wright Brothers were dealing with a natural physical force, the downward pressure exerted on bond yields has been an artificial phenomenon.
Through aggressively cutting overnight rates and the implementation of Quantitative Easing, central bankers have pushed interest rates to generational lows. But with global economies gaining rather than losing steam and few signs of faltering amidst the strength, the central banks are poised to reverse polarity.
If our memory of force diagrams from high school physics serves us correctly, by removing gravity and applying upward pressure, rates should rise. Even though investors and markets are expecting this, there is much uncertainty about the pace and magnitude of the rise, and the impact of removing stimulus.
Given that we broke our crystal ball and the countless paths interest rates could take, we prefer to focus on where we are and what we know to gain some insights into where we might be going.
From 2015 to 2017 the US, Europe, and Japan issued USD 3.77 trillion of debt. Over the same period, the Bank of Japan (BoJ) and European Central Bank (ECB) purchased USD 4.88 trillion of sovereign bonds. The sheer scale of the purchasing programs is believed to have lowered yields by more than 1%. While the BoJ will likely continue its buying, the ECB is expected to start scaling back later this year. The great unknown is what yields will investors require to shed other assets and fill the void left by the central banks.
Turning our attention to economic health, things are going very well south of the border. It is highly probable that the large dose of fiscal stimulus (tax reform and deregulation), delivered at a time of low unemployment (4.1%), will eventually translate into wage growth. In the near term, real GDP and inflation could reach 3% and 2% respectively. A 5% nominal GDP (compared to around 4% for the past decade) coupled with the government needing to fund a growing deficit by borrowing USD 200 billion more than last year, and it isn’t surprising that yields have been rising. Perhaps the biggest surprise is that the move hasn’t been larger.
The picture in Canada is a bit murkier due to concerns around the indebtedness of our fellow citizens and other potential headwinds for the economy. The Bank of Canada has responded to tremendous employment growth by raising rates 0.75% since July. On the surface, this may not seem like much, but some estimate that the increase in debt service costs will shave 0.7% off disposable income. With 60% of our domestic GPD coming from consumer spending, this could create a 0.4% drag on growth.
The hope is that exports and capital investment will pick up the slack. Although deals with Europe and Asia are positive for trade, the lack of clarity around NAFTA may hurt exports and capital spending. These factors won’t likely be powerful enough to alter the upward direction of Canadian rates but could limit the extent of the move or slow the pace of increase.
Further complicating the domestic interest rate outlook is the global nature of sovereign bond markets, with demand from international investors often determining the yields at which governments can finance debt. This means that interest rate moves in one part of the world can spill over to other jurisdictions. As long the government needs to access debt markets, their bonds will have to offer attractive yields relative to other countries, even if the preference is to keep rates low.
While we agree with Yogi Berra, that ‘it’s tough to make predictions, especially about the future,’ from what we know today, it does appear that interest rates are on an upward trajectory. But as early aviators discovered, the journey higher can take many different paths and often involves bouts of turbulence.
The Fund
On Friday, February 2nd, our Fund turned three years old, and like many new parents, we’re surprised at how the time has flown. As we have said before, it takes a village to raise a Fund, and we would like to mark this milestone by thanking all our ‘villagers’ for your tremendous support.
In January, credit markets zigged while bond and equity markets zagged. With interest rates moving higher the Canadian Universe Bond Index was down (0.8)%, the TSX dropped (1.36)%, but the momentum in credit continued as spreads tightened 8-9 bps. Corporate new issues started off slowly but picked up materially as the month progressed. These deals were very well received as the demand for corporate bonds remained extremely robust.
On top of the general performance in credit, the Fund benefitted from exposure to REITs and bank subordinated debt which outperformed other sectors. We did take some profits by trimming positions into the rally. We were also rewarded for having increased our floating rate note (FRN) holdings over the past several months, as rising rates saw demand for these securities pick up. We added to this exposure in January but are paying close attention to valuations on these offerings as the heightened demand for FRNs has tightened coupon spreads.
Through maintaining tight interest rate hedges and capitalizing on the performance in credit, the net result was a gain of 1.19% on the month.
| Year | YTD | |
|---|---|---|
| 2018 | 1.19% | 1.19% |
| 2017 | 0.50% | 8.46% |
| 2016 | 1.62% | 23.15% |
| 2015 | 0.87% | 15.86% |
Credit
All eyes are on the shaky equity markets, and this is certainly the near-term focus. Although credit markets have been more orderly, spreads are trading moderately wider. Sustained weakness in stocks should lead to further widening.
On a positive note, dealer inventories are currently on the lighter side (especially in the US), and the supply calendar looks very manageable. Also, volatile markets tend to reduce the propensity for dealers to bring new issues even though rising yields make them more attractive.
We continue to maintain a modest risk exposure, with positions concentrated in shorter-dated securities. We will be proceeding with great caution, looking for attractive opportunities, and remain prepared to increase our hedging activity if warranted.
Rates
The Bank of Canada raised the overnight rate 25bps and bond yields moved roughly 20bps higher in January. Neither the Bank of Canada nor the Federal Reserve meets in February. The bond bears should not care because both banks are on track to raise their respective overnight rates two or three more times this year.
Regards,
The Algonquin Team
Talkin’ ‘Bout My Generation | December 2017
“Children now love luxury. They have bad manners, contempt for authority, disrespect their elders, and love talking instead of exercise.”
Socrates
It is every generation’s prerogative to opine on and decry the ones that follow. But instead of shaking their fists and complaining about Millennials, the wiser grey-haired executives are preoccupied with understanding how to market to and manage them. As Canada’s and America’s largest living cohort comes of age, so too rises their relevance as producers, consumers, and investors.
It is estimated that by 2020 Millennials will represent 50% of the global workforce and have a net worth in the ballpark of $19-21 trillion, having doubled assets since 2015. They will not only benefit from increased earnings but also from a wave of inheritances, as the majority of managed wealth currently resides with those over the age of 60. So as time goes on, it will be increasingly important for financial institutions, asset managers, and investors to understand how this generation will put their money to work.
And perhaps the best starting point is to look at how they are currently managing their nest egg.
Despite carrying hefty debt burdens, Millennials are good at saving. But reports suggest that the vast majority of them do not hold equities, preferring physical assets and cash. Much of this has been attributed to the Great Recession. Not only were many of them entering a terribly difficult job market, but they were also scarred from watching their parents and grandparents suffer losses in 2008. As a result, they are reluctant to put their hard-earned savings at risk.
A report released by Merrill Edge suggests that the crisis also created mistrust in the financial system amongst Millennials and an underlying feeling that they are better off relying on their efforts, leading to most of them managing their own wealth. But rather than being aggressive youngsters, 85% of them say that they ‘play-it-safe,’ with 46% claiming they are more conservative than their parents.
While they may be risk-averse, the first digital generation is unquestionably more comfortable with technology and algorithmic portfolio management. This has led to Robo-advisors managing hundreds of billions of dollars, a number that is expected to snowball in the coming years. As an example, the Canadian start-up Wealthsimple has accumulated over $1bn in assets under management in less than three years.
Another trend amongst the young ‘punks’ is the move towards socially responsible and impact investing. According to research from Deloitte, almost two-thirds of Millennials are not only concerned about the state of the world but also feel obliged to do something about it. This has been one of the factors behind the tremendous growth in sustainable investing, with 1 in every 5 dollars invested in Canada and the US falling under this umbrella.
Just as Boomers reshaped the world to fit their needs and desires, bringing us ‘sex, drugs and rock ‘n’ roll,’ so too will the Millennials profoundly change business and culture to conform with their values and biases. And whether or not the older folks are ready to pass on the baton, the Millennials will be grabbing it with both hands and leaving their mark on all aspects of society. It is, therefore, very worthwhile to try and understand them and the future they are creating.
The Fund
Fortunately, the credit markets made it onto the ‘nice’ list, and were gifted an invite to participate in the ‘Santa Claus rally.’ With new issue supply ending mid-month, dealer inventories were drawn down leading to a modest performance in credit. With this final grind tighter, 2017 saw corporate spreads lower by 27bps in Canada and 29bps in the US. This performance was in spite of record corporate new issuance of C$116 billion, with the slack from lighter bank supply picked up by foreign companies such as Apple and Pepsi.
As can be expected, there was little in the way of trading activity and opportunities in December. Over the month we added to our FRN positions and exited some hedges which had been creating a mild drag on performance. The carry earned and spread tightening generated a return of 50bps in December.
| Year | Dec | YTD |
|---|---|---|
| 2017 | 0.50% | 8.46% |
| 2016 | 1.62% | 23.15% |
| 2015 | 0.87% | 15.86% |
Credit
Near-term momentum remains bullish as dealer inventories are light, and there seems to be a slow start to new deals. Tailwinds at the moment are rising yields and US tax reform. In rising rate environments, portfolio managers favour corporate over government debt, as the higher coupon helps offset losses when yields rise. The tax changes south of the border make it less desirable for some corporations to borrow money since not all interest payments are tax deductible. Furthermore, companies may repatriate foreign cash reserves to be used for capital expenditures, stock repurchases, and M&A.
Although the macroeconomic conditions and corporate fundamentals are constructive for credit, we remain a little cautious given that spreads are at the tighter end of the range and are patiently waiting for opportunities.
Rates
It appears that 2018 will be the year of interest rate normalization. Most countries are experiencing robust economic and employment growth. Fiscal stimulus in the US comes with unemployment at 4%, while in Canada significant minimum wage increases in Alberta and Ontario could be passed on to consumers. Although inflation has not yet climbed, there is a growing unease that perhaps it will do so this year.
Central banks will have little choice but to continue hiking and scaling back on quantitative easing. As such, rates should continue to rise in the coming months. The only question is by how much. For Boomers who might still remember (if they can) 13% mortgages, 4-5% is still ridiculously low, while it could be a shock for Millennials who have more experience with sub 3% mortgages. Needless to say, we will keep the portfolio’s interest rate risk tightly hedged.
Regards,
The Algonquin Team
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Much Ado About Nothing | November 2017
“Doing nothing is very hard to do…you never know when you’re finished.”
Leslie Nielsen
In a world that values and incentivizes action, ‘doing nothing’ carries with it certain negative connotations. It conjures up images of laziness and complacency or succumbing to inertia and the status quo. But there are often times when doing nothing is our best option, and it’s usually when it is the hardest thing to do (or not do).
A famous medical example is the insertion of stents, tiny wire cages, to open narrowed arteries in the heart. Studies have shown that for patients with stable chest pain this invasive procedure is no more effective than taking medications. Despite this evidence and the risks of the procedure, many cardiologists continue inserting stents, finding it hard to believe that nothing can be better than something.
Perhaps this is why in training army officers to make combat decisions, one of the most valuable pieces of advice is ‘doing nothing is also a decision.’ While inaction on the battlefield may not be a particularly wise choice, when investing money, sometimes doing less yields more desirable results. After all, most of us can think of a time when we would have been better off sitting on our hands.
In their paper, ‘Trading Is Hazardous to Your Wealth,’ Brad Barber and Terrance Odean concluded that the more retail investors traded, the further their performance lagged the market. While the commissions and costs of transacting contribute to this lag in returns, the underlying theme is that we are often our own worst enemies due to overconfidence and poor market timing.
This effect is also chronicled in Morningstar’s annual ‘Mind the Gap’ report. These reports analyze the difference between a mutual fund’s net return and that earned by the average investor in that fund. In the 2017 report, the gap for Canadians over the last five years was -1.09%. The obvious question is why are people underperforming to such a degree? The costly difference is mainly attributed to the timing and magnitude of the inflows and outflows into and out of the funds.
Put simply, this ‘behavioral return gap’ is caused by buying high and selling low, with people piling into investments during periods of strong returns and running for the exits when results are poor. The fear of missing out pushes us to chase good performers, and the bitter pain of loss leads us to sell at the troughs.
Naturally the definition of ‘doing nothing,’ is broad, and it needn’t imply the sort of laziness or inertia that gyms rely on to have more members than they could fit through their doors. For some, it simply means following a passive investment strategy, while for active managers, it could mean patiently letting winners run or adopting a defensive posture in the late stages of a bull market.
No matter how one chooses to define it, following through can be very difficult. A runaway bear or bull market will test the resolve of a passive investor to stay the course, and an active manager always needs to resist the urge to tinker simply because they feel they ought to. In both cases, discipline is required and an understanding that doing nothing is something and sometimes it is the best option.
The Fund
Corporate spreads experienced a modest tightening in Canada and a small widening south of the border. The weakness in the US market was led by a sell-off in High Yield combined with bloated US dealer inventories caused by higher than average new issuance. As a result, recent CAD$ bonds issued by foreign corporations into Canada (“Maples”) weakened in sympathy. US credit spreads did stage a partial recovery late in the month which stabilized the Maples.
Domestically, corporate issuers were busy, setting a record for November volumes in addition to year-to-date gross issuance. Metro Inc. was the most notable issue as $1.2B was sold in 5, 10 and 30 year tranches. Although the deal looked expensive, it was widely placed and performed well. As a consequence, the retail sector outperformed as credit curves were repriced tighter.
The Fund benefited from the move in the retail sector and positions in REITs, energy, and banks. A portion of these gains was offset by losses from Maples and credit hedges. The net effect was a November return of 0.45%.
| Year | Nov | YTD |
|---|---|---|
| 2017 | 0.45% | 7.91% |
| 2016 | 1.60% | 23.15% |
| 2015 | 1.37% | 15.86% |
Credit
As usual, equities get all the attention when it comes to the ‘Santa Claus rally,’ however, credit often participates as well. Not only do corporate bonds get a boost because of rising stocks, but new issue supply all but disappears during the latter half of December. Typically, this leads to a drawdown of dealer inventories as cash continues to be put to work resulting in a steady bid for corporate debt. The prospects of significant tax cuts south of the border are so far driving the rally. As long as those efforts don’t falter and barring any macro tape bombs, credit spreads should grind tighter over the next few weeks.
Rates
It is becoming increasingly difficult for central bankers to do nothing. The global economy continues to strengthen as unemployment rates steadily decline. So far, wage growth and inflation pressures have been muted, but the risks remain tilted towards both firming in 2018.
The Bank of Canada continues to be cautious given the uncertainty surrounding trade negotiations and housing, as well as the impact of higher rates on over-levered consumers. Despite these factors, they are likely on a path to raising the overnight rate a few times next year.
The Federal Reserve is expected to raise rates later this month and is on track for two to three further hikes in 2018. If the US administration is correct in their assumption that tax cuts will lead to 3+% GDP growth, the Fed might have to be far more aggressive than anticipated.
Regards,
The Algonquin Team
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The Choice is Yours | October 2017
“Choices are the hinges of destiny.”
Pythagoras
Amidst all the catchy click-here headlines, several contenders vie for the title of ‘the most important investment decision you’ll ever make.’ Setting aside the hyperbole of ‘the most important ever’ and filtering for common themes, we arrive at a set of choices that drive investment success.
Questions such as what career path to follow, how much to save, what asset mix to have, and who should steward your portfolio are at the top of most lists. But underlying and influencing all of these is a life choice that is often made without any thought of the financial outcome.
A choice that Warren Buffet considers the biggest decision you will ever make: your choice of spouse/partner or the lack thereof.
Now, this might seem terribly unromantic and hark back to days when marriages were arranged for political, economic, and social convenience. To be clear, our intention is not to advocate for such considerations to influence a choice of this magnitude, but instead, to shed some light on the direct and indirect affects one’s partner will have on significant financial decisions.
Take for example asset allocation. The question of what assets to own, in what proportions, and when to change the mix. There is a host of evidence pointing to this as the single largest determinant of a portfolio’s performance, having a more significant impact than the selection of individual securities. The right asset mix will be based on your needs, objectives, and risk tolerance, all of which are determined and defined as a couple.
Now there are those that say the most critical thing isn’t where or how you invest, but how much. As preached to young folk, saving early and often harnesses the power of compound returns. How much you tuck away depends heavily on your and your spouse’s spending habits. Whether you’re both spendthrifts or savers or a combination of the two will largely determine how much you’re able to put into your investment portfolio. And as all parents can attest, so will the number of kids you have.
One step further down the ladder is what drives the savings rate for most of us; household income. Beyond the combined salary and earning potential of the couple, there is also the support that they will provide each other towards achieving career goals. As Facebook COO Sheryl Sandberg wrote in her book Lean In, “the single most important career decision that a woman makes is whether she will have a life partner and who that partner is.”
If you do choose to have a life partner, the romantics in us hope that your investment portfolio is not top of mind in the selection process. But the pragmatists in us do feel, while it may be unexciting and unromantic, that couples should engage in open dialogue about setting and achieving financial goals. And an important part of this is understanding the influences, both positive and negative, that each person has.
Now, as prudent money managers, we invariably seek to manage and mitigate downside risks. With that in mind, we would like to conclude by saying to our spouses/partners, that being with them is by far the best decision we’ve ever made.
The Fund
October brought the credit markets more treats than tricks. A healthy earnings season combined with a very manageable $8B in domestic new issuance and continued demand for corporate bonds, saw credit spreads tighten throughout the month. The lack of alarming geopolitical headlines also contributed to the positive tone. In the end, corporate spread indices were lower by 5bps in Canada and 6bps in the US.
Amongst the new deals, Disney brought a C$1.25B 7-year issue, as the ‘Maple’ market continues to offer Canadians unique and diversified exposure through foreign issuers. In general, there is substantial demand for new corporate bonds with order books significantly oversubscribed.
While the Fund was positioned more conservatively, we were able to capture some of the performance in credit, especially through actively managed exposures to higher-beta names. Narrowing spreads combined with carry resulted in a gain of 0.83% on the month.
| Year | Oct | YTD |
|---|---|---|
| 2017 | 0.83% | 7.42% |
| 2016 | 1.86% | 23.15% |
| 2015 | 1.71% | 15.86% |
Credit
It appears that the robust demand for corporate debt will persist a little longer, with cash available to digest what appears to be a reasonable issuance calendar ahead. Opportunistic borrowers such as the banks and provinces will likely take advantage of the current environment. While there are geopolitical concerns rumbling in the background with the chance of sudden escalation, economic conditions are supportive for corporations.
On the other hand, from time to time, signs of “froth” in the market surface. As a result, we continue to maintain modest positions, batting for singles and protecting the plate.
Rates
The Bank of Canada not only opted to hold rates steady but also signaled their intention to move cautiously. Their tone suggests that policy-makers prefer to allow time to pass before assessing how the recent hikes affect the economy. This prudent approach to reducing stimulus, soothed bond traders, prompting a 10bps to 15bps decline in yields.
The noise surrounding the selection of a new Chair to the Board of Governors of the Federal Reserve can often roil fixed income markets. While there were a few jitters, the appointment of Jerome Powell promises subdued volatility as he favours a continuation of the snail-like pace of monetary tightening.
Given the ‘steady as it goes’ approach by central banks, bond investors will face few difficult choices in the coming weeks.
Regards,
The Algonquin Team
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The Law of Unintended Consequences | September 2017
“The road to hell is paved with good intentions.”
Proverb
One of the great dilemmas in moral philosophy is whether actions should be judged based on their intentions or consequences. The difficulty, of course, arises when the impact of our intentions are unforeseen, unexpected, or unintended.
This concept of unintended consequences was popularized by the twentieth-century sociologist Robert K. Merton. In his 1936 paper,”The Unanticipated Consequences of Purposive Social Action”, Merton examined the causes behind and the types of unanticipated outcomes. These ranged from pleasant surprises to perverse results, where the action backfires producing the opposite of the desired effect.
Take for instance the British Raj’s (not to be confused with the Algonquin raj) attempt to curb the cobra population in Delhi by offering a bounty for each dead snake. The plan was a success until some enterprising people started breeding cobras for income. Eventually, the scheme became so big, that authorities were forced to scrap the program, causing the cobra breeders to release their now worthless snakes. In the end, the net effect of the initiative was to increase the cobra population.
Another historical backfire was the ‘Four Pests’ campaign during Chairman Mao’s Great Leap Forward. The Chairman introduced a new hygiene initiative that targeted rats, flies, mosquitoes, and sparrows. Because the sparrows ate the grain that the farmers sowed, Mao believed they were depressing crop yields. Unfortunately, he didn’t realize that the sparrows also consumed vast quantities of locusts. Once the sparrow population was decimated, the locust swarms took over the country, devouring entire crop fields at a time, leading to mass starvation.
These examples serve as reminders for us at a time when several complex ‘government actions’ are unfolding or about to unfold. The Federal Reserve will commence their exit from quantitative easing, the Bank of Canada (BoC) may continue increasing interest rates, and there is the potential for significant changes to the tax codes on both sides of the border.
Over the course of three quantitative easing programs, the Federal Reserve acquired $4.5 trillion in assets which lowered long-term government bond yields by an estimated 1%. Although the Fed believes their exit plan will be an orderly one, there is a non-trivial chance it won’t be. After all, where is the $4.5 trillion going to come from to fill the void when they step back?
On the domestic front, the BoC is bent on adding volatility to the bond market as they remain tight-lipped about their plans. In a world, where central bankers are opting for a very slow withdrawal of stimulus, the Bank’s eagerness to hike stands out as an anomaly. At this point, it’s interesting to note, that one of the earliest references to unforeseen outcomes was in a letter from John Locke to Sir John Somers (MP) about the unintended impact of interest rate regulation.
Lastly, the ‘minor tweak’ proposed by the Canadian government, is the most significant change to the tax code in years, while the promised US tax overhaul may end up being only temporary. As tax policy affects return on capital, succession planning, business expansion plans, etc. it is difficult for the bureaucrats to predict the medium and long-term consequences of their planned changes.
We are not necessarily foreshadowing doom and gloom, as “undesired effects are not always undesirable” (Merton, 1936). But given the sheer scale and complexity of these endeavors, it seems reasonable to “expect unexpecteds” (Algonquin raj, 2017).
The Fund
September was a busy month with approximately $15bn of new issues coming to market. While domestic bank supply continues to underwhelm (due to international issuance) foreign and corporate issuers have more than picked up the slack. Amongst the new deals were infrequent issuers such as Capital Power, Morguard, and Finning. Enbridge also brought a subordinated “hybrid” deal, and the Maple market (foreign issuers bringing C$ deals into Canada) continues to be very robust providing diversification for domestic investors.
Despite the heavy volume, there is lots of cash available for new issues as the deals were well received and oversubscribed. The positive reception resulted in credit spreads remaining roughly unchanged.
Stable spreads allowed the fund to capture all its carry, and the increased deal flow presented several good trading opportunities, leading to a 0.70% return for September.
| Year | Sep | YTD |
|---|---|---|
| 2017 | 0.70% | 6.53% |
| 2016 | 1.01% | 23.15% |
| 2015 | 1.68% | 15.86% |
Credit
Last month’s good momentum should make for a busy October. The rates traders will agonize over every data release, while the credit crowd will have several deals to muddy their hands.
Despite interest rates moving higher after the Bank of Canada hike, we see no evidence of investors pulling back from fixed income. Instead, higher yields might be attracting new money or prompting some folks to add duration to their portfolios.
We see a couple of positive tailwinds ahead. First of all, there are a growing number of strategists calling for Canadian equities to close the performance gap with other markets. Should this occur, the enthusiasm will likely spill over from equities to corporate debt. The other factor is US tax reform. Although a detailed plan is months away, it does appear that reform will reduce the incentive, need, or both for corporations to borrow money. The scarcity of product could lead to a healthy rally in corporate debt.
Rates
Yields are clearly on the rise. The Federal Reserve will commence the exit from quantitative easing in October and is now widely expected to raise rates in December. Governor Poloz is holding his cards ‘tight to the chest,’ however, he does seem bent on raising rates over the next year or so. Although bond yields have risen, the market has been quite orderly. A wild card could be the European Central Bank which is expected to reveal its exit plan in the coming months.
Given the complexity of unwinding the buying programs, a small difference in procedure could result in a big difference in the outcome. Accordingly, one should be prepared to be surprised.
Regards,
The Algonquin Team
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When Volatility Knocks | August 2017
“Using volatility as a measure of risk is nuts.”
Charlie Munger
The future is full of possibilities, some good some bad. Risk comes from not knowing which of them will come to pass. Given it’s impossible to imagine and consider every potential outcome, we focus our energy on the most likely ones.
In market speak, the ‘probable’ range of outcomes is expressed as volatility. A useful metric that fits nicely into models and gives an indication of the ups and downs one can expect to endure. The trouble investors run into is when they use it as a proxy for risk.
While investment risks are both broad and personal, they typically fall into the categories of losing money or not making enough of it. Both of which are more a function of valuation and sound fundamentals rather than of mercurial markets.
The best way to protect and grow capital is to buy quality assets at attractive prices. Given its propensity to spike after significant equity declines, high volatility often indicates the opportunity to do just that. To ‘be greedy when others are fearful.’
Conversely, periods of stability can lead to an underestimation of uncertainty in the market and the odds of the ‘improbable’ occurring. Often when it is prudent to be ‘fearful when others are greedy.’
So how should investors use and interpret volatility?
The first step is in recognizing what volatility is and is not. It is not a substitute for risk but is one measure of a particular type of risk. For those with short-term horizons or trading with leverage, it is a real concern, and substantial variations in value need careful management.
But for the majority of us, portfolio fluctuations are tolerable as long as the overall trend is up. After all, one would prefer an investment that generates positive but erratic returns, rather than one that consistently and steadily loses money.
Perhaps then volatility’s appropriate value is as a measure of fear, or the lack thereof. As a gauge of investor sentiment, it can provide both an indication of near-term threats and longer-term opportunities. The natural question is whether the level of complacency or fear is warranted. When valuations and fundamentals do not support the ‘wisdom of the crowd,’ it might be time to be either prudent or aggressive.
It’s not that volatility is not a useful and valuable risk metric. We are not ones to throw the baby out with the bath water. But taken in isolation, the picture is imperfect and incomplete. After all, quantitative metrics can help us understand risk, not define it.
The Fund
It seems we spent the month dodging missiles of one kind or another. A sleepy mid-summer market was jolted with a sharp escalation in rhetoric between the US and North Korea causing credit to give up some ground.
Just as the war of words appeared to abate, the new issue supply floodgates opened. Pembina got the ball rolling, but it was Apple’s inaugural Canadian deal, a $2.5B record-breaker, that caught everyone by surprise. To absorb the supply, investors took the same approach one does when confronted with eating an elephant; one bite at a time!
Just as the deal flow had been digested, another North Korean missile test frayed everyone’s nerves. By the time August was over, credit spreads were 4 to 10 bps wider on the month. Furthermore, activity on the Korean peninsula meant little in the way of active trading opportunities.
Although the fund was positioned defensively in very short-dated securities, the carry earned just wasn’t enough to cover losses from widening spreads. As a result, the fund experienced a modest loss of (0.09%).
| Year | Aug | YTD |
|---|---|---|
| 2017 | (0.09)% | 5.80% |
| 2016 | 1.63% | 23.15% |
| 2015 | (0.25)% | 15.86% |
Credit
August is a notoriously difficult month for trading credit with many bank desks short staffed due to summer holidays. Fortunately, once September hits, the market often comes alive with new deals and increased flow.
The combination of geopolitical risks and new supply could create a volatile landscape. But the recent widening of spreads offers more attractive entry levels and the pick up in activity can lead to interesting opportunities. After having played defense through the summer, we are watching closely for chances to strike.
Rates
While the missile tests did not faze equity folks, the bond crowd opted for safety driving yields 4 to 20 bps lower across the curve. The various central banks continue to lean towards a reduction in stimulus, including the Bank of Canada. Perhaps the most perplexing observation is that despite increases in the overnight rates and imminent exits from quantitative easing, long-dated yields remain low.
To be fair, inflation data is benign, and wage growth has been surprisingly weak despite low unemployment rates. Although interest rate volatility is low, valuations are high, so we remain cautious.
Regards,
The Algonquin Team
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Alternative Facts for Alternative Investors | July 2017
“All generalizations are dangerous, even this one.”
Alexandre Dumas
Across the taxonomy of investment products, the hedge fund category invokes some rather extreme reactions. On the one hand, there are images of ruthless and greedy managers, whose performance doesn’t always justify their fees or egos. On the flip side, you have some of the world’s best performing endowments and pension plans advocating significant allocations to alternatives as part of a well balanced and diversified portfolio.
The difficulty in forming any concrete conclusions or opinions is that they make one guilty of generalizing a very diverse and broad industry. After all, hedge funds are defined based on the legal structure of the offerings and not the underlying investments. While the original conception was long/short equity funds, the category has grown with strategies ranging across asset classes and the risk spectrum. There are even folks that view the Canadian hedge fund industry as a unique animal unto itself, with its’ very own appeal.
At this point, the typical Canadian reaction is: Really? Why would global portfolio managers care about our little alternative market?
The argument is that Canadian capital markets are smaller and less liquid, creating more inefficiencies for active managers to exploit. Also, there is less competition chasing these opportunities relative to larger markets. Furthermore, investors are drawn to the smaller size of Canadian offerings, with the advantage of being more nimble and able to execute niche strategies.
From what we have been able to gather, the best estimate of the size of the industry in Canada is $35bn across approximately 150 funds, with the majority of them managing less than $50mm each. To put that into perspective, our entire industry would have difficulty cracking the list of top 5 hedge funds by assets. Bridgewater, AQR, and Renaissance Technologies alone combine for over $233bn under management.
While this data is supportive of the hypotheses, as we all learnt in science class, it’s the results that count. Since its inception in 2005 to the end of June 2017, the annualized return of the Scotia Bank Canadian Hedge Fund Index was 6.76%. Over the same period, the annualized gains of the HRFX Global Hedge Fund Index and the TSX were 0.73% and 6.98% respectively. It is worth noting that the hedge fund figures are net of fees whereas the TSX returns are gross. Furthermore, the Scotia Index exhibited about 30% less volatility than the Canadian stock market.
We offer this data to provide a broad perspective of the industry but would caution against overemphasizing a fund’s performance in isolation. Too often allocations to alternatives are driven by a chase for high returns when we would argue the purpose of adding ‘alts’ to your portfolio is diversification.
While traditional public markets offer many baskets to put your eggs in, you also have to make sure these baskets are not all on the same shelf. Today’s alternative funds provide a broad range of return stream, from merger arbitrage and private debt to wine and cryptocurrencies. The key is to find investments that zig when the rest of your portfolio zags, to help you smooth returns, reduce volatility, and sleep better at night.
The Fund
Domestic credit markets followed the summer script last month. Supply was light ($7.8bn) and spreads ground modestly tighter. We saw robust demand for financials, buoyed by FTSE Russell deciding to include bank NVCC debt in the Canada Universe Bond Index. Although widely expected, the announcement was a catalyst for bank spread tightening. The star performer in July was the energy sector with spreads performing on the back of rising commodity prices.
The portfolio was well positioned for the month in both rates and credit. While the increase in yields saw the domestic bond index down 1.90%, our hedges and trading generated a positive return through the rate move. On the credit side, the carry was bolstered by exposure to outperforming securities and active trading. In particular, we benefitted from exposure to bank debt and from a position we exited in long CNQ bonds which rallied 20bps. The result was a strong monthly gain of 0.94%.
| Year | Jul | YTD |
|---|---|---|
| 2017 | 0.94% | 5.89% |
| 2016 | 1.73% | 23.15% |
| 2015 | 0.73% | 15.86% |
The Credit
Barring any surprises, we anticipate August to follow the summer theme, with another month of light issuance and dull markets. Things become more interesting as September approaches, with portfolio managers repositioning ahead of the expected Fall supply. As history has shown us, the market impact of the new issuance isn’t clear cut.
If the new deals are well received and perform strongly, they can take secondary spreads along for the ride tighter. Alternatively, if the amount of supply is overwhelming, spreads could react poorly. Accordingly, we have positioned our portfolio to retain flexibility and to take advantage of the opportunities created by the flows around new deals.
Rates
With the Bank of Canada and Federal Reserve hikes behind us, attention turns towards September when the Federal Reserve is expected to commence the tapering operation. It also seems that the ECB is ready to join the party and will provide some insight into how they intend to manage their exit from quantitative easing.
The central banks have done an admirable job convincing everyone that the ‘exit’ should be a rather smooth process. For this to play out according to their script, private capital would have to step in and buy the debt that central banks no longer need. We wonder what the source of this cash will be. If it requires the sale of other assets, we imagine that yields would need to be quite a bit higher to entice folks to move from other investments into government debt.
Regards,
The Algonquin Team
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Are We There Yet | June 2017
If you don’t know where you’re going, you’ll end up someplace else.
Yogi Berra
With the kids out of school, families across the country are packing up their cars and embarking on summer road trips. Journeys filled with bad dad jokes, frequent pee stops, and that oh too familiar backseat chorus.
‘Are we there yet?’
After years of wondering when interest rates will rise, the 0.45% increase in the Canadian 5 year yield in June has many bond investors asking the very same question. While the markets have cried wolf before only to see rates back down a month or two later, there is the nagging feeling that this time is different.
Previously, rising yields were met with central bankers steadfastly beating the drum of deflationary concern. No amount of economic data could shake their belief that the abyss of deflation lurked around the corner. As a result, they implemented and maintained the extraordinary measures of negative real (and nominal) rates and quantitative easing to stimulate economic growth.
Although lacking hard evidence that inflation is rising, policymakers have begun to change their tune. The Federal Reserve has laid out how it will begin its tapering process. The ECB has started to mull an exit from quantitative easing and negative rates. And even the Bank of Canada publicly stated that the economy had recovered from the shock of plunging oil prices.
The abrupt change of heart by the Bank of Canada caught many flat-footed. Despite the domestic economy performing better than predicted, CPI has not been particularly strong. And since economic growth hasn’t led to rising inflation in the G7, concerns around the perils of excessively low rates had faded.
Nonetheless, those driving the car have determined that deflation risks have considerably diminished and that reflationary forces now have the upper hand. As a result, they seem to be quite willing to remove the ‘emergency’ or ‘insurance’ stimulus that they have been relying on since the ‘Great Recession.’
Based on the data this may seem premature. But CPI tends to lag GDP growth, and changes to monetary policy can take several months to have an impact. Thus central bankers have to make decisions based on forecasts and often act before the economic numbers exhibit significant change.
So while we might not be there yet, it appears we are finishing the long stretch of the deflationary highway and moving onto the side roads. And like kids waking up when the car changes speed on the off-ramp, the Canadian market is now preparing for an interest rate hike tomorrow, the first in seven years.
Over the balance of the year, we expect to see a modest rise in yields, particularly once central banks commence the tapering process. But as is so often the case after a long road trip, the visibility on the side roads can be poor, and we can expect a bumpy and unpredictable ride en route to our final destination.
The Fund
After a record-breaking amount of new issues in May, supply moderated in June to a mere $8B, the lowest print for the month since 2012. This breather gave the market an opportunity to digest the excess issuance from May. As a result, credit traded sideways for the first half of June before tightening towards month end, despite negative returns in equities and bonds.
Bank NVCC was the star performer of the month, narrowing over 20 bps on the news that newly issued bonds (and potentially the existing ones as well) are to be included in the FTSE TMX index. The only laggard in June was Oil & Gas, which was knocked back by the violent move lower in commodity prices. However, the sector did begin to recover late in the month along with the price of oil, as investors took advantage of some compelling credit spread levels.
With the portfolio’s interest rate sensitivity tightly hedged, the significant jump in yields had a minimal impact on the return. The improvement in credit spreads coupled with the interest earned contributed to a gain of 0.53% for the month.
| Year | Jun | YTD |
|---|---|---|
| 2017 | 0.53% | 4.91% |
| 2016 | 0.54% | 23.15% |
| 2015 | 0.25% | 15.86% |
Credit
For many, the summer equates to vacation time. The corporate bond market often takes this theme to heart, so the supply of new issues can be light. Portfolio managers are thus forced to pick away at secondary offerings to deploy cash. The resulting reduction in dealer inventories can create the right environment for a steady “grind tighter” in credit spreads. Barring any “tape bombs” (or should we say “Twitter bombs”?), we would expect a modestly constructive summer for credit.
We have added to our floating rate notes while reducing the credit duration of more cyclical names. We feel a prudent exposure to bank NVCC debt is warranted based on the already mentioned bond index developments.
Rates
Both the Bank of Canada (July 12th) and the Federal Reserve (July 26th) meet this month. The market has the odds of the Bank of Canada hiking 25 bps in the region of 90%. The great debate following the meeting will be whether another 25 bps hike will come in September or whether the Bank of Canada will wait until late fall to raise rates again.
Federal Reserve Chair Yellen and company are poised to commence a far trickier operation as they exit quantitative easing. To avoid confusion, the Fed will take a pause from hiking, to focus on the mechanics and impact of exiting their purchasing program. We, therefore, expect them to be on hold until the end of the year and raise rates 25 bps in December.
As the central banks change course, investors have to hope they know where they’re going.
Regards,
The Algonquin Team
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The Lure Of The Long Ball | May, 2017
It could be, it might be…it is! A home run!
Harry Caray
The Home Run. With one single swing of the bat, all the baserunners and the batter come home to score. For a hitter, it doesn’t get much better than knocking the ball out of the park.
Between them, Reggie Jackson, Jim Thome, Adam Dunn, Sammy Sosa, and Alex Rodriguez have had 2,942 of these magical moments and rank amongst the most prolific sluggers in the game. They are also the five players with the most career strikeouts. Barry Bonds, the home run leader, with 762, struck out more than twice that much.
These men were willing to strike out to swing for the fences. Perhaps the same can be said of those chasing investment homers.
Both types of home runs are high risk, high reward ventures, and both can be game changers. The difference is the magnitude of those risks and rewards.
In baseball, it’s strike three, and you’re out. But this is a game where even the best hitters get out 60% of the time. So the worst case is an out, and the winning team will have at least 24 of those. On the other hand, when you’re swinging for investment homers, you face the potential of a total loss of capital.
As for upsides, the maximum in baseball is four runs; a ‘grand salami.’ On the investment side, it is relatively unbounded. Think of early investors in Facebook, Amazon, and Google. Peter Thiel cashed out on over $1 billion in Facebook stock from an initial investment of $500k.
That’s exciting stuff, and the lure of hunting such opportunities is strong. Psychologists and neuroscientists have even compared this excitement to the effects of cocaine on the brain. And under the haze of a potentially big payoff, there is the tendency to overlook or underemphasize the risks.
The other push to swing for the fences is the fear of missing out (FOMO). Unlike baseball, where you never know what could have been if you had gone for it, in investing, the future will painfully show when you passed on a big winner.
This anticipation of regret and the draw of the big payoff can have us chasing too many bad pitches in search of the moon shot. As grizzled baseball managers would remind us, you can’t try to knock it out of the park every trip to the plate. While it would be fun to watch an entire line-up of sluggers swinging for the fences, that approach might not fare well over a 162-game season.
A winning team and a robust portfolio consist of all types of players. And there are an infinite number of player combinations that can result in success. You just have to choose the right mix and balance for you. The lovely thing about investing is that, unlike baseball, everyone can be a winner.
The Fund
After eight months in a row of steady narrowing, domestic credit spreads finally buckled under the weight of a record-breaking $15.65 billion of new issuance. The abundance of supply coupled with concerns related to Canadian real estate (especially the GTA) pushed spreads generically wider by 10 bps.
Housing worries and Moody’s downgrade of the big six domestic banks prompted selling in mortgage-related names and helped drive Bank NVCC roughly 18 bps wider while deposit notes moved out 10 bps. It is no surprise that REITs were hit especially hard, with spreads wider by over 20 bps. Fears of a slowdown in US auto sales and a class action lawsuit launched against GM pushed auto paper out around 10 bps. We also saw significant profit taking in telco paper which had performed well for several months.
Despite holding mostly shorter maturities in our portfolio, the fund lost 0.22% in May as losses from credit spread widening were only partially offset by interest carry and active trading.
| Year | May | YTD |
|---|---|---|
| 2017 | (0.22)% | 4.35% |
| 2016 | 0.60% | 23.15% |
| 2015 | 2.46% | 15.86% |
Credit
US credit was largely unchanged in May, supporting the view that supply was the primary cause of the lousy performance of Canadian corporate bonds. Question marks surrounding the health of the GTA housing market will likely linger for several months as people wait for more data.
The new issue calendar looks robust for the first half of June. This may result in credit spreads trading ‘sideways’ through the month. However, a likely slowdown in primary supply over July and August may create the required conditions for a more constructive credit environment.
Our sense is that May was about a healthy correction and that barring an external shock, the corporate bond market will be less volatile in June. Rather than swinging hard, we will look to ‘hit for average’ this month.
Rates
The surprise coming out of the Bank of Canada meeting was that Governor Poloz sounded slightly more optimistic about the economy than expected. Meanwhile, south of the border the pundits are calling for a ‘quarter point’ hike by the Federal Reserve.
Oddly enough, despite the seemingly ‘bearish’ news for bonds, yields moved 5 to 10 bps lower. Perhaps the move is related to concerns that President Trump will be unable to deliver on promised fiscal stimulus or because US economic data has been uninspiring. While the reasons behind the move are murky, it is important to note the change in tone. Interest rates may be an ominous signal that the global economic picture may not be as rosy as it appears.
Regards,
The Algonquin Team
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Data Bites | April, 2017
He uses statistics as a drunken man uses lamp-posts – for support rather than illumination.
Andrew Lang
Data is like coffee shops. These days it is everywhere and in abundance. It doesn’t matter whether you are building a hockey team, managing investments, or picking the fastest route home, there are a lot of numbers being crunched. We could be living through the first period in history where statisticians are cool.
New technology has afforded us the ability to access and process vast amounts of data. In theory, this should enable us to make more informed and rational choices instead of relying on ‘gut feel.’ But until algorithms are making all our decisions and driving our cars, we humans have to sort through and interpret this overwhelming flow of information.
The first challenge is selecting and determining what measurements are relevant. This can be especially tricky when confronted with divergent or contradictory evidence and is further compounded by our tendency to concentrate on material that confirms our pre-existing beliefs. Ultimately, what we choose to focus on and ignore will shape the views we form.
Once the data has been selected, it must then be analyzed. When interpreting the facts, we must be wary of any disconnect between what the numbers say and what people feel to be true. In such cases, evidence-based conclusions may not jive with the behaviour of consumers, voters, and market participants. As seasoned investors know, despite what the numbers indicate, markets can go from irrational to very irrational and stay there for a long time.
There is also the question of the quality of the data and the methods being used to analyze it. This is not just a shot at fake news, but an important consideration for scientific research. This why academics often review the findings of their peers, sometimes with surprising results. After all, as statistics show, 80% of statistics are made up.
Even when the data is good, we run the risk of confusing correlation and causation. A fun illustration of this was presented over two decades ago by David Leinweber and Dave Krider. They found a 75% correlation between butter production in Bangladesh and the S&P500. Adding US cheese production improved this to 95% and introducing a third variable; sheep population, resulted in a regression that explained 99% of the US stock market. As nonsensical as this seems, they apparently still get phone calls from people wondering what the butter indicator is saying.
Finally, there is the illusion of precision that can come from cold hard facts and numbers. There is a certain amount of confidence that is inspired by the exactness of 4.523. This can lead us to be precisely wrong rather than approximately right. With all the tools available to us, it is easy to overemphasize what we can measure and ignore what we can’t.
We have no doubt that making decisions based on hard evidence helps us avoid hidden biases, popular misconceptions, and wishful thinking. But a plethora of information also makes the decision-making process extremely complicated. Perhaps the greatest irony of the preponderance of data is that good judgment matters even more.
The Fund
Aside from the Home Capital debacle at the end of the month, it was smooth sailing for the markets in April. Canadian credit continued to perform, led by higher-quality long bonds and solid ‘Triple B’ names. Bank NVCC has been the star performer narrowing 55 bps so far this year. We elected to take profits and exit our position and will wait patiently for a re-entry point.
We did not have any exposure to Home Capital, and when the OSC allegations became public, we reduced/exited positions in regional lenders. Exposure to the outperforming sectors coupled with carry contributed to a strong performance of 1.03% in April.
| Year | Apr | YTD |
|---|---|---|
| 2017 | 1.03% | 4.58% |
| 2016 | 3.51% | 23.15% |
| 2015 | 1.27% | 15.86% |
Credit
Home Capital continues to dominate our radar screen. They have three outstanding bond issues trading in the low ‘nineties’ including one that matures on May 24th. It is clear that people are worried about how this story plays out.
Their business model is based on funding long-term assets (mortgages) with large short-term borrowing (high-interest savings accounts and GICs). The recent run on deposits is a “loss of confidence” story, and it is hard to imagine how management can stem the withdrawals. As veterans of the 2008 financial crisis, we know that fear is contagious and can lead to knock-on effects impacting other lenders including the banks. Since the problem isn’t to do with the quality of the mortgages themselves, but rather a loss of confidence in Home Capital, it is likely that this mess is an isolated one.
Outside of the financial space, we expect the demand for credit to remain robust. Until there is some resolution to the Home Capital saga, we will maintain a medium risk posture.
Rates
In what seems to be the normal pattern, US first-quarter data was uninspiring. Furthermore, it is becoming apparent that President Trump’s ambitious agenda will likely unfold at a much slower pace than originally anticipated, and will likely be less aggressive than the platform he campaigned upon. As a result, US yields drifted roughly ten bps lower during the month. Even though Canadian GDP was quite good, many believe the results are transitory which took Canadian rates lower by the same amount.
The Federal Reserve has signaled that the US economy is expanding as expected so remains poised to lift rates as early as June. Meanwhile, the Bank of Canada will almost certainly leave rates unchanged and provide a cautious outlook when they meet on May 24th.
Regards,
The Algonquin Team
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Not So Quiet on the Western Front | March, 2017
“The machine gun is a much over-rated weapon.”
Field Marshal Douglas Haig, Commander British Expeditionary Force 1915-1918
With the 100th anniversary of Vimy Ridge approaching, we take a look back at this historic battle, and why four Canadian divisions, fighting together for the first time, were able to capture a German position where the British and French had been unsuccessful for two years.
World War I has the sad distinction of being one of the deadliest conflicts in human history, with over 17 million killed and more than 20 million wounded. One of the reasons for the significant number of military casualties was the tremendous strides in weaponry just before and during the war. The machine gun, heavy artillery, aircraft, barbed wire, armoured vehicles, and chemical weapons were put to frighteningly efficient use.
Unfortunately, the generals were utterly unprepared to cope with the new technology. During the early years of the conflict, they still relied on Napoleonic tactics that depended on cavalry and short range cannons. Perhaps the Battle of the Somme, where nearly 60,000 British soldiers fell on the first day of battle, epitomizes the catastrophic results of failing to adapt to change.
So what did the Canadian Expeditionary Force, under the leadership of Lieutenant-General Sir Julian Byng*, do differently?
Historians attribute the success of the Canadian Corps to meticulous planning, extensive training, powerful artillery support, and a mixture of technical and tactical innovation. Canadian’s pioneered the science behind the effective use of artillery and perfected small unit fire and movement tactics. Also, recognizing that the men in leadership positions were likely to be wounded or killed, soldiers learned the jobs of those beside and above them.
While we cannot compare the hardships of the Great War with the challenges facing the modern investor, we can learn a lesson about questioning if the methods that worked in the past can deal with the future.
An important component of this is challenging the assumptions that underlie our approach. At a high strategic level, this involves reassessing asset and geographic allocations against changes in capital markets, global economics, the geopolitical landscape, and of course, your objectives. In a low-interest rate world, where people are living longer, does pegging your fixed income allocation to your age still make sense?
At a more tactical level, there is the question of how to fill your investment buckets; which specific strategies and exposures to select. Between a plethora of low-cost ETFs and access to esoteric, niche products, the consumer is spoilt for choice. The question now is whether our existing models can evaluate this larger and ever-changing set of opportunities. As an example, with the movement to green energy and online viewing and shopping, how do we value traditional energy, broadcasting, and retail companies?
The status quo is comfortable, especially when it has worked in the past. But with the current pace of change, investors need to challenge the conventional wisdom and consider whether different approaches might yield better results. Like the generals of the Great War, much will be learned through trial and error, but these mistakes might pale in comparison to remaining stuck in your ways.
The Fund
Mariners used the expression ‘doldrums’ when referring to calm periods when the winds disappear altogether, trapping sailing vessels for days or even weeks. The term seems appropriate in describing the corporate bond market in March. Due to mounting valuation concerns, credit spreads ‘toed-and-froed,’ with some sectors widening while others narrowed slightly.
An exception was CNQ, which announced a surprise acquisition that immediately widened its credit spreads 15 to 20bps as investors considered rating implications and braced for significant issuance in the near future. The CNQ bonds we owned resulted in a small loss to the fund. We exited a majority of our exposure, expecting an opportunity to participate in a new deal if the pricing is attractive.
With little in the way of interesting opportunities, we elected to maintain a lower risk profile. The hiccup with CNQ and weakness in the energy sector was offset by gains in bank NVCC debt and our small preferred share holdings. With the movements in credit being a wash, active trading and carry resulted in a gain of 0.44% for the month.
| Year | Mar | YTD |
|---|---|---|
| 2017 | 0.44% | 3.51% |
| 2016 | 5.32% | 23.15% |
| 2015 | 2.51% | 15.86% |
The Algonquin Debt Strategies Fund LP was launched on February 2, 2015. Monthly returns are based on ‘Series 1 X Founder’s Class’ NAV as calculated by SGGG Fund Services Inc. and are shown in Canadian dollars, net of all fees and expenses.
Credit
The issuance calendar for early April appears light, but that could change as various energy and REIT names come to market. Regarding credit spreads, we expect a similar pattern to March with modest widening or tightening depending on the sector. Trial balloons related to US tax reform, and the first round of the French presidential election on April 23rd could provide a few trading opportunities. To maintain flexibility we have exited positions in ‘triple B low’ credits such as Cominar and Shaw while adding to other higher rated names.
Rates
Interest rates continue to trade in a narrow range. Canadian economic data surprised everyone with its strength. However, Governor Poloz repeated his cautious outlook, which isn’t surprising given the lack of clarity on potential NAFTA renegotiation. We expect the Bank of Canada to keep the status quo until there is clarity on trade policy.
Events in Europe are starting to make headlines. Some signs of economic strength are emerging on the continent, leading to speculation about when and how the ECB will exit quantitative easing. As we’ve pointed out in the past, the ECB’s program is important when trying to predict moves in the domestic bond market.
Regards,
The Algonquin Team