Monthly commentary discusses recent developments across both the Diversified Bond and Credit Income Opportunities Funds.
After stabilizing in April, economic data took a turn for the worse in May. Weakness was broad, with disappointing PMIs in the U.S, Europe and China. Non-farm payrolls were also very weak in the U.S., with a gain of only 75 thousand jobs, well short of consensus expectations for a 170 thousand gain. Real time indicators of US Q2 GDP now track at about 1.3%, well below the 3.1% realized in Q1. Overall, the green shoots that were visible early this spring have all but disappeared (Figure 1).
Source: Goldman Sachs
Against this negative economic backdrop, trade rethoric has meaningfully stepped up. The tone between China and the U.S. has become acrimonious, with both sides blaming the other for reneging on previously agreed upon provisions. To make matters worse, the U.S. has also imposed trade restrictions on the Chinese telecom giant Huawei, effectively barring the company from purchasing critical technology from American companies. Talks have now broken down and it has become clear to us that US/China trade tensions are here to stay. The dispute is not solely about the trade deficit, it is about maintaining the US hegemony vis-à-vis China. The tone on both sides has gone from bad to worse and we do not think that this will be solved any time soon. As such, we do not expect much from the G20 meeting at the end of June and assume the imposition of further tariffs on Chinese imports.
To add fuel to the fire, Trump opened a new dimension to the trade war by threatening tariffs on Mexico as leverage to solve immigration issues. While the tariffs did not go into effect after last minute negotiations, this is a particularly important development as it relates to future trade deals. The Mexican parliament was in the process of ratifying the new free trade agreement with the U.S. and Canada when this threat was made. That signals to us, and to the rest of the world, that any agreement with Trump and his administration can be rescinded at any time, for any unrelated reason. This realization by political and business leaders makes it increasingly unlikely that anyone would want to make long term decisions (trade agreements by governments, investment decisions by firms and market participants, etc.) in such an uncertain climate.
As such, we believe that business confidence has been permanently eroded by these developments and that it is unlikely we see a sustained rebound in the world economy. The bond market seems to agree; the yield curve has further inverted in Canada and the U.S., reaching levels not seen since 2006. Our recession prediction model now signals a 46% chance of recession 12 months from now (Figure 2). Of note, the entire yield curve in Canada now trades below the overnight rate.
Figure 2: Probability of Recession is going up
Central bankers have taken notice; both the Federal Reserve and the ECB have acknowledged the increase in uncertainty and the associated downside risks to the economy. The question is no longer if, but when they will introduce additional easing. The market is now pricing two rate cuts by the Fed this year and more in 2020. In the Euro Zone, Mario Draghi has signaled that all tools were at their disposal (rate cuts, QE, forward guidance) to introduce additional easing. Given the transition to a new (and potentially hawkish) ECB President in the fall, we would not be surprised to see Draghi act forcefully this summer to force his successor’s hand in a more dovish direction.
Credit continues to perform surprisingly well; in Canadian Investment Grade (IG), spreads were about flat. Spreads are now back to the top end of their old trading range of 110-120bps.
In High Yield (HY), spreads widened almost 90bps with the decline in equity markets. However, they have since then recouped most of their losses.
Given the downside risks to the macroeconomic environment and the signals from the bond market, we find it odd that credit and equities have behaved so well; there seems to be some cognitive dissonance in the bullish narrative. For now, equities seem to believe that the Fed will come to the rescue by cutting rates, and that this will be enough to extend the cycle. Accordingly, bad economic data has been received with higher equity prices (i.e. bad is good environment). At the time of writing, the S&P 500 is within striking distance of new all-time highs and with bond yields as low as they are (U.S. 10 year bond at a multi-year low of 2.1%), financial conditions are very accommodative. In this context, barring real economic downside risk, it is hard to see the Fed cutting rates. But this market is already assuming that the Fed will cut rates, so it will likely be disappointed if it doesn’t.
On the flip side, if the Fed does cut rates, it is because things are taking a turn for the worse. We would then expect earnings estimates to move lower and economic data to continue to disappoint. In this state of the world, it is hard to see equities and credit perform well, let alone stay at all time highs.
There is very little the Fed (or other central banks) can do to offset a negative shock to confidence induced by reckless trade policies emanating from the White House.
Diversified Bond Fund (DBF)
May was a good month for the DBF, returning 86bps as interest rate declines far outweighed minor credit spread widening. We continue to increase duration and our government bond allocation, consistent with our investment framework and macroeconomic views. We are adding to our 30-year U.S. government positions on pullbacks, seeing those as the best bang-for-our-buck in a risk-off/recession environment. Since month end, we have further increased our duration to 4.4 years.
Our investment grade position, while still a substantial 64% of the portfolio, is very conservative, with a duration of 2.7 years and yield to maturity of 3%, of which a third matures within a year. We are active in the new issue market, when pricing is adequate, but at this juncture we are increasingly selective, keeping credit risk low, duration low and liquidity high.
Diversified Bond Fund Portfolio Characteristics:
Source: Ninepoint Partners
Credit Income Opportunities Fund (Credit Opps)
May was another solid month for the Credit Opps, with a net return of 72bps on Series A. Returns were driven by three major factors. First, as discussed previously, Canadian investment grade credit continues to perform well. Second, the fund had a 6% position in U.S. 30-year government bonds through the TLT ETF (along with an option overlay), which benefited from the strong rally in duration. Finally, our very small and relatively defensive HY positions were unimpacted by the mid-month volatility in equity markets, but our HY hedges (through HYG options) generated gains. With the quick reversal in risk assets mentioned above, some of the hedging gains have now been reversed. For now, we intend to keep this position as we expect more volatility around the G20 meeting in Japan at the end of June.
Credit Income Opportunities Portfolio Characteristics:
Source: Ninepoint Partners
With the deterioration in global economic data and the worsening of trade tensions, we expect markets to become more volatile, both on the upside and the downside. After a strong start to the year, we aim to be prudent and keep the portfolios liquid, so that we can act from a position of strength.
Until next month,
The Bond Team: Mark, Etienne and Chris
1 All Ninepoint Diversified Bond Fund returns and fund details are a) based on Series F units; b) net of fees; c) annualized if period is greater than one year; d) as at May 31, 2019 1 All Ninepoint Credit Income Opportunities Fund returns and fund details are a) based on Class A units (closed to subscriptions); b) net of fees; c) annualized if period is greater than one year; d) as at May 31, 2019.
The Ninepoint Diversified Bond Fund is generally exposed to the following risks. See the prospectus of the Fund for a description of these risks: Capital depletion risk (Series T, Series FT, Series PT, Series PFT, Series QT, and Series QFT shares only); Capital gains risk; Class risk; Concentration risk; Credit risk; Currency risk; Cybersecurity risk; Derivatives risk; Exchange traded funds risk; Foreign investment risk; Inflation risk; Interest rate risk; Liquidity risk; Regulatory risk; Securities lending, repurchase and reverse repurchase transactions risk; Series risk; Short selling risk; Specific issuer risk; Tax risk; Tracking risk.
The Ninepoint Credit Income Opportunities Fund is generally exposed to the following risks. See the offering memorandum of the Fund for a description of these risks: General Economic and Market Conditions; Assessment of the Market; Not a Public Mutual Fund; Limited Operating History for the Fund; Class Risk; Charges to the Fund; Changes in Investment Objective, Strategies and Restrictions; Unitholders not Entitled to Participate in Management; Dependence of the Manager on Key Personnel; Reliance on the Manager; Resale Restrictions; Illiquidity; Possible Effect of Redemptions; Liability of Unitholders; Potential Indemnification Obligations; Lack of Independent Experts Representing Unitholders; No Involvement of Unaffiliated Selling Agent; Valuation of the Fund’s Investments; Concentration; Foreign Investment Risk; Illiquidity of Underlying Investments; Tax; Litigation; Fixed Income Securities; Equity Securities; Idle Cash; Currency Risk; Suspension of Trading.
Ninepoint Credit Income Opportunities Fund is offered on a private placement basis pursuant to an offering memorandum and are only available to investors who meet certain eligibility or minimum purchase amount requirements under applicable securities legislation. The offering memorandum contains important information about the Funds, including their investment objective and strategies, purchase options, applicable management fees, performance fees, other charges and expenses, and should be read carefully before investing in the Funds. Performance data represents past performance of the Fund and is not indicative of future performance. Data based on performance history of less than five years may not give prospective investors enough information to base investment decisions on. Please contact your own personal advisor on your particular circumstance. This communication does not constitute an offer to sell or solicitation to purchase securities of the Fund.
Ninepoint Partners LP is the investment manager to the Ninepoint Funds (collectively, the “Funds”). Commissions, trailing commissions, management fees, performance fees (if any), other charges and expenses all may be associated with mutual fund investments. Please read the prospectus carefully before investing. The indicated rate of return for series F units of the Fund for the period ended May 31, 2019 is based on the historical annual compounded total return including changes in unit value and reinvestment of all distributions and does not take into account sales, redemption, distribution or optional charges or income taxes payable by any unitholder that would have reduced returns. Mutual funds are not guaranteed, their values change frequently and past performance may not be repeated. The information contained herein does not constitute an offer or solicitation by anyone in the United States or in any other jurisdiction in which such an offer or solicitation is not authorized or to any person to whom it is unlawful to make such an offer or solicitation. Prospective investors who are not resident in Canada should contact their financial advisor to determine whether securities of the Fund may be lawfully sold in their jurisdiction.
The opinions, estimates and projections (“information”) contained within this report are solely those of Ninepoint Partners LP and are subject to change without notice. Ninepoint Partners makes every effort to ensure that the information has been derived from sources believed to be reliable and accurate. However, Ninepoint Partners assumes no responsibility for any losses or damages, whether direct or indirect, which arise out of the use of this information. Ninepoint Partners is not under any obligation to update or keep current the information contained herein. The information should not be regarded by recipients as a substitute for the exercise of their own judgment. Please contact your own personal advisor on your particular circumstances. Views expressed regarding a particular company, security, industry or market sector should not be considered an indication of trading intent of any investment funds managed by Ninepoint Partners LP. Any reference to a particular company is for illustrative purposes only and should not to be considered as investment advice or a recommendation to buy or sell nor should it be considered as an indication of how the portfolio of any investment fund managed by Ninepoint Partners LP is or will be invested. Ninepoint Partners LP and/or its affiliates may collectively beneficially own/control 1% or more of any class of the equity securities of the issuers mentioned in this report. Ninepoint Partners LP and/or its affiliates may hold short position in any class of the equity securities of the issuers mentioned in this report. During the preceding 12 months, Ninepoint Partners LP and/or its affiliates may have received remuneration other than normal course investment advisory or trade execution services from the issuers mentioned in this report.
Ninepoint Partners LP: Toll Free: 1.866.299.9906. DEALER SERVICES: CIBC Mellon GSSC Record Keeping Services: Toll Free: 1.877.358.0540