Joseph Sirdevan & Scott Connell – Galibier Capital Management Ltd.
“Volatility is the friend of the long term investor” – Warren Buffett
And “volatile” sums up the performance of the markets in the first quarter of 2016. Changing expectations for the direction of future interest rate movements were a major source of the markets’ gyrations as were weak commodity prices and continued sluggishness of general economic conditions.
At Galibier, we love short-term volatility. Why? Because we focus on the long term in deriving our view of individual company valuations. Thus, when a volatile market gives us stock prices that are well below our view of intrinsic value we buy. And when the market gives us stock prices well above intrinsic value we sell and redeploy capital into names with more upside potential.
Despite the incredible volatility during the quarter, the Canadian market was ultimately quite strong, finishing up +4.5%. The U.S. market was equally volatile but, when reported in Canadian dollar terms, was down -5.6% in Q1 2016.
The first quarter was marked by a series of dramatic market moves, largely caused by rising investor concern over the ongoing fall in oil prices and uncertainty over the state of both the Chinese economy and the European banking sector. Developed market government bond yields fell sharply, led by longer maturities, after both the European Central Bank and the Bank of Japan unveiled additional unconventional monetary stimulus and the US Federal Reserve signalled it would be slower in further raising rates. Riskier developed market assets were especially volatile, with equity prices declining significantly and credit spreads widening sharply early in the quarter before experiencing a rebound late in the period. The US dollar underperformed against most currencies, helping to boost emerging market bond and equity returns (both local currency and US dollar). Movements in commodities were mixed, with oil prices rising and natural gas prices falling.
The FTSE TMX Canada All Corporate Bond Index generated positive returns for the quarter. Corporate bonds outperformed duration-matched Government of Canada bonds, as spreads generally tightened.
While Canadian equity markets saw defensive stocks handily outperform the more cyclical areas of the market in 2015, the first quarter of 2016 has seen the much maligned economically sensitive sectors of the market rise strongly off of lows formed in January. The Canadian equity market easily outperformed its southern peer as commodities and commodity-linked sectors such as Energy, Materials and Industrials showed signs of life. Fixed income markets also had a good quarter in Canada where corporate bonds largely outperformed governments. In short, despite a rough start in January it was a generally a good quarter to be invested in the markets as illustrated below.
EXHIBIT 1: MARKET & FUND PERFORMANCE
Note: All returns are in Canadian dollars Source: Bloomberg, NGAM Canada LP
With that said, the quarterly performance figures shown in Exhibit 1 smooth over the high level of volatility experienced by investors during the quarter. As shown in Exhibit 2, the quarter was particularly bumpy in US equity markets. Currency movements over the quarter also did not help the Canadian dollar (CAD) value of US equity investments as the 6%+ appreciation of the CAD vs. the USD pressured returns.
EXHIBIT 2: MONTHLY MARKET PERFORMANCE
Source: Bloomberg, NGAM Canada LP
The US Federal Reserve’s decision to raise the Federal Funds Target Rate in December further increased the divergence between the US monetary policy and that of the world’s other major central banks and likely contributed to the financial market volatility experienced in the first quarter. Equity market volatility ramped up into mid-February and saw the VIX top 28 while WTI crude oil fell to US$26 per barrel. As Q1 progressed, mixed economic reports and falling asset prices led investors to scale back their expectations for further US monetary tightening and financial asset prices subsequently improved. Earlier market-implied predictions of four US Federal Funds Target Rate increases in 2016 fell to just one and, as of the writing of this commentary, are implying that the next rate hike will not occur until February 2017.
Government bond yields continued to grind lower throughout the quarter, (Exhibit 3), and corporate credit spreads improved after widening out during 2015 to levels not seen since the 2011 European debt crisis. The US dollar continued to weaken against major cross currencies which helped place a bid under commodities and commodity-linked currencies.
EXHIBIT 3: GOVERNMENT BOND YIELDS MOVED LOWER
Within the North American equity markets, performance was broadly positive in almost all sectors with the notable exception of Health Care and US Financials (Exhibit 4). Thematically speaking, the flight to safety early in the quarter prompted strong performance in interest rate sensitive sectors such as Telecommunications, Utilities, and Consumer Staples, while a resurgence in oil prices during the second half of the quarter helped the Energy, Industrial, and Canadian Financial sectors. Both base and precious metals stocks also performed exceptionally well. Health Care was the only losing sector in Canada with the bulk of the negative returns related to Valeant’s well documented legal, accounting, and regulatory issues.
EXHIBIT 4: EQUITY SECTOR PERFORMANCE
Oil prices have broadly improved since our last commentary as reduced drilling activity and rumours of OPEC production caps have excited investors. Despite this welcome bounce in oil prices, we are still concerned that the changes on the supply side of the energy equation are more structural than cyclical in nature. Producer market share objectives, increased global supply (Iran) combined with improved technology (fracking) have materially lowered the cost structure and time to market of the marginal barrel. Lower costs have partially mitigated the negative impact of lower prices and led to more durable production levels than many anticipated. On top of this, we have little faith in a supply reduction agreement between major producers as OPEC members have a poor history of compliance with such agreements and typically act in their own best interest. On the demand side of the energy equation, the situation has remained largely unchanged. The world continues to consume +96 million barrels per day, which should only grow slowly over time with population growth and emerging economy development. However, demand growth will be variable as continued low levels of GDP growth and increased interest in renewables and other fossil fuel alternatives all present cyclical and secular headwinds.
In summary, while energy prices have bounced nicely and taken energy equities and credit with them, we view this as more technical than fundamentally driven at this point and have used the opportunity to trim some positions and high grade our energy related exposure. As we wrote in our previous commentary, the energy sector will have its day in the sun again, but we believe the upside is capped in the current economic environment, and thus while we will continue to have some presence in the sector, we prefer to allocate more capital to areas with long-term secular growth opportunities.
NEXGEN FUNDS & INVESTMENT OUTLOOK
Performance of the Funds during the first quarter was positive, and while they did not beat their respective benchmarks, we remain comfortable with the fund positioning. In terms of negative contributors to performance during the first quarter, our US Health Care names such as Pfizer and Abbott Laboratories underperformed as the sector digested noise on the political front. In addition, WPT Industrial REIT fell after an unsuccessful sale process, but has since regained some of the losses. Industrial Alliance was hurt by falling interest rates and challenges in their wealth business, and finally Newalta, which conducted a large dilutive share issue, saw pressure and has since been sold. Looking at the biggest positive contributors to performance, our Canadian bank positions performed well despite a tenuous start to the year. SNC-Lavalin continued to climb and close the discount to our conservatively estimated NAV, while Dream Office REIT bounced with energy and a very accretive buyback announcement. Alaris Royalty continued to perform well as it beat expectations and announced a strong pipeline of opportunities to allocate capital. Finally, Pembina Pipeline rebounded with energy prices and the announcement of a highly accretive asset acquisition.
In our prior commentary we discussed increasing our cash position. Since then we have put some of this cash to work. We have participated in a few recent secondary stock and rights offerings by companies with strong management teams and good prospects for long term growth and have been active in areas such as Energy infrastructure, REITS, Industrials, and Utilities.
While we are somewhat cautious, we see enough opportunity to remain largely invested. We are closely monitoring valuations, earnings and corporate commentary while also keeping abreast of the myriad of larger order concerns affecting the markets. Uncertainty around negative bond yields, energy prices, economic growth, “Brexit”, and US elections will continue to add volatility to asset prices and, as always, we will stay vigilant and continue to look for opportunities to purchase shares in good companies at attractive valuations as opportunities arise.
For more information about NexGen Canadian Dividend Fundsor NexGen Canadian Diversified Income Funds, please contact your financial advisor.
All performance data is as of March 31, 2016.
Performance for the NexGen Canadian Dividend Tax Managed Fund, Capital Gains Class, Front End Load Regular Series – 1 month: 6.0%; 3 months: 2.2%; 6 months: 2.6%; 1 year: -5.5%; 3 years: 3.9%; 5 years: 4.4% and Since Inception*: 3.0%. Performance for the NexGen Canadian Dividend Registered Fund, Front End Load, Regular Series – 1 month: 6.0%; 3 months: 2.2%; 6 months: 2.6%; 1 year: -5.5%; 3 years: 3.8%; 5 years: 4.3% and Since Inception*: 3.0%. *Inception Date: Sept. 5, 2006
Performance for the NexGen Canadian Diversified Income Tax Managed Fund, Capital Gains Class, Front End Load Regular Series – 1 month: 5.1%; 3 months: 1.2%; 6 months: 1.8%; 1 year: -4.5%; 3 years: 3.2%; 5 years: 3.3% and Since Inception*: 0.0%. Performance for the NexGen Canadian Diversified Income Registered Fund, Front End Load, Regular Series – 1 month: 5.1%; 3 months: 1.3%; 6 months: 1.8%; 1 year: -4.4%; 3 years: 3.2%; 5 years: 3.3% and Since Inception*: 0.0%. *Inception Date: Sept. 5, 2006
Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. The indicated rates of return are the historical annual compounded total returns including changes in share value and reinvestment of all dividends and distributions and do not take into account sales, redemptions, distributions or optional charges or income taxes payable by any securityholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer.
U.S. equity markets continued their strong rebound into March as recovering commodity prices, a falling U.S. dollar, and improving economic releases have dispelled investor fears of an imminent recession in the U.S. The S&P 500 Index advanced 12.6%* from the low of 1,829.08 on February 11 and closed the month at 2,059.74, just shy of this year’s high reached the prior day. The slight increase in risk sentiment led small-cap stocks to outperform large-cap stocks for the month. Small-cap stocks measured by the Russell 2000 Index rose 8.0%* while large-cap stocks represented by the S&P 500 gained 6.8%*.
The first quarter of 2016 was really a “Tale of Two Cities” in the major financial markets. The first few weeks saw severe selloffs in most markets with many having their worst start to a year in history. The Canadian stock market, as evidenced by the S&P/TSX Index, was down over 8% in the first 2 weeks of the year as was the S&P 500 in the U.S. The carnage in Asia & Europe was even worse with those markets being down approximately 20% in the first 5 weeks of the year. Due to the conservative positioning of the NexGen Turtle Canadian Balanced Fund, unitholders weathered this downturn fairly well with capital being protected. I believe that one of the main factors driving these sharp selloffs was change in positioning by the U.S Federal Reserve (“U.S. Fed”) as they began to “normalize” interest rates by raising the Fed Funds rate in December and commenting that they would raise rates further in the near future. As I have indicated on several occasions in the past, I believe that much of the market advances over the past few years have been driven by the ridiculously easy monetary policy of the global Central Banks led by the U.S. Fed. As it became apparent that maybe this easing was coming to an end, the markets sold off sharply.
Invest better: Commissions, trailing commissions, management fees and expenses all may be associated with mutual fund investments. Please read the prospectus before investing. Mutual funds are not guaranteed, their values change frequently and past performance may not
be repeated. Mutual fund securities are not covered by the Canada Deposit Insurance Corporation or by any other government deposit insurer.