Monthly Commentaries

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.

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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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.

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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“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.

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

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“Memory is deceptive because it is colored by today’s events.”
Albert Einstein

Suppose your doctor tells you that you must undergo an uncomfortable medical examination and that there are two choices available.

Option A: 8 minutes of sharp, intense pain and the procedure ends.

Option B: The same 8 minutes of intense pain as Option A, followed by an additional 16 minutes of moderate pain, concluding with some mild discomfort.

At this point, you’re probably considering switching doctors. Oddly enough, despite how ludicrous the second choice seems, it may give you a better memory of the experience.

This is not to say you are a masochist, but this was the surprising result of a study conducted by Daniel Kahneman and UofT’s Donald Redelmeier. They asked colonoscopy patients to rate the intensity of pain at one-minute intervals as well as give an overall pain rating afterwards. Their findings drew an interesting distinction between the experience and the memory of the procedure, offering evidence of a heuristic known as the peak-end rule.

The peak-end rule states that our memory formulates an opinion of an experience based on how we feel at its most intense point and at the end, remaining largely indifferent to the duration and the sum of the individual moments.

For example, Patient A goes through an 8-minute examination with a peak pain of 8 (out of 10) and in the last minute a rating of 7. Patient B experiences the same 8 minutes, and for the next 16 minutes is exposed to varying degrees of pain, finishing with a mild discomfort registering a lowly rating of 1.

When asked to rate the overall experience, Patient A gives it a 7.5 on the pain scale while Patient B gives it a much lower rating of 4.5. This despite the process lasting three times longer and the person enduring a much greater aggregate amount of discomfort.

Thankfully anaesthetics are administered for colonoscopies now, but the peak-end rule has much wider and deeper implications. In the wonderful world of investing, history is often used as a guide to gain perspective. This particular bias leads us to overemphasize market extremes and give disproportional weight to recent events. Because 2008 left an indelible mark on investors; they may find themselves overly referencing this period as well as the most current market events in their analysis.

The problem with this is that it ignores important considerations such as the passage of time, the fact that markets can spend ages at fair valuations, and changes to the macroeconomic fundamentals. Without careful analysis and thought, there is a significant risk of jumping to erroneous conclusions.

When we base investment decisions purely on gut-feel or intuition, we are relying heavily on our memory. Unfortunately, the peak-end rule and a host of other biases indicate that our memory is not ‘all that it is cracked up to be.’

The Fund

Credit spreads continued to tighten in February with ongoing demand for higher-yielding names. Domestic bank subordinated debt (NVCC) outperformed, and the fund benefitted from this. New issue activity was abnormally light to start the month but bounced back strongly in the second half. Deals were priced with no concession (and in some cases negative concessions) to existing secondary levels. Despite this, the new deals performed extremely well. Amongst this supply, two energy focused names came to market as Canadian high yield issuers continue to offer a steady stream of new financings. Notably, domestic banks were absent from the Canadian primary market after their earnings season. They chose instead to finance in international markets.

Although we maintained a modest exposure, the narrowing of credit and interest carry contributed to a solid 1.30% gain in February.

The Credit

The adage that ‘March comes in like a lion’ also applies to new issues. Given the sustained demand for credit, deals should continue to perform well. Increased primary activity often creates good opportunities in secondary product as investment managers attempt to reposition portfolios, and bond dealers manage their inventories. Despite the positive tone in credit markets of late, we are taking a more cautious approach. Moderate risk positioning and an increased focus on sector and security selection seem appropriate to us.

The Rates

Despite some recent strength in Canadian employment figures, the Bank of Canada preferred to highlight that the economy faces a material degree of excess capacity. As such, Governor Poloz is likely to remain on hold for the balance of 2017. The caveat being any adverse impact from US fiscal policy that would warrant further easing.
Governor Yellen and her colleagues at the Federal Reserve have made it clear that a rate increase in March is nearly a done deal. Should the US economy continue to strengthen, the Federal Reserve will probably hike two more times, bringing the 2017 total to 75bps. The measured pace of hiking coupled with on-going quantitative easing by the European Central Bank and the Bank of Japan makes it difficult for yields to rocket higher. Instead, the bond bears will have to be content with a painfully slow rise in interest rates.

Regards,
The Algonquin Team

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“DON’T PANIC.”
Douglas Adams,‘The Hitchhiker’s Guide to the Galaxy’

Through the early days of Trump’s presidency, we found ourselves reminded of Arthur Dent; regular Earth-person and protagonist of ‘The Hitchhiker’s Guide to the Galaxy.’ After discovering that both his house and planet are to be destroyed, Dent must negotiate a series of increasingly unpredictable and bizarre events.

Following some of the President’s more controversial first moves, many earthlings may even empathize with another of the book’s characters, Marvin the depressed robot, who held the view: ‘Loathe it or ignore it. You can’t like it.”

From an investment perspective, perhaps the relevant line is: ‘Like it or loathe it. You can’t ignore it.’ Or can you?

The investors’ predicament is a difficult one, and they don’t have the benefit of a handy guide for navigating the new administration. On the one hand, lower corporate taxes, deregulation, and fiscal stimulus bode well for business confidence. But against this backdrop are the President’s unpredictability and the potential for trade wars between the US and, well, the rest of the world.

Should the US employ trade tariffs, the reaction of the affected countries is impossible to predict. And while it may be ‘America First,’ the law of unintended consequences could cause ‘the First’ some pain. Business leaders don’t like uncertainty. So despite the government’s efforts to create jobs, companies may decide to ‘hunker down,’ and wait out the storm.

We expect all of this to lead to a challenging and volatile environment. Perhaps the best course of action is to ‘Ignore it or like it.’

Those following passive strategies can ignore the asset price gyrations and simply enjoy the circus show. After all, the markets have managed to deal with far more turbulent periods and have rewarded the long-term, patient investor, very well.

Active managers may face a dizzying array of opportunities and risks to manage. The opportunities should present themselves not only in general market levels, but also within sectors and individual companies. Events ranging from ‘twitter-attacks’ to changes in the tax code, regulations and trade agreements will change the playing field for many businesses. In this type of environment, with the potential for market overreactions, astute investors will likely be able to pick up a bargain or two.

The risk is that this is much easier said than done. It requires analytical rigour, objectivity, and a strong stomach, as ‘mistakes’ will be unavoidable. And when in doubt, or just dumbfounded, don’t panic, remember the answer is 42.

The Fund

We started the year with our analysis providing a conflicting view on domestic credit markets. While the technicals and sentiment were supportive of credit spreads, the rally into year-end and the outright levels indicated that caution was warranted. Accordingly, we adopted a medium risk posture and remained on high alert for any indications of weakness.

In the end, it was like carrying an umbrella on a cloudy day with no rain. Our caution, while perhaps prudent, was proven unnecessary. With new bond issues well oversubscribed, portfolio managers were forced to do their buying in secondary markets, pushing spreads tighter. We were able to add to the returns from carry and credit spread tightening through tactical trading to end up with a 1.73% gain for the month.

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

We continue to be cautious around credit spreads, mainly because we can’t make the case that they are cheap. However, it is just as difficult to make a case that they are very expensive. Portfolio managers seem to have cash to put to work, the new issue calendar is unusually light, and higher rates are attracting yield starved buyers. The situation is ideal for corporations who are able to raise debt without paying a concession.

In spite of these positive fundamentals, the market may be a ‘tweet’ away from a sharp ‘Trump Dump,’ and given our desire to retain flexibility, maintaining a medium risk posture continues to be an appropriate course of action.

Rates

US economic data still points to a strengthening economy, which coupled with fiscal stimulus, keeps the Federal Reserve on track to raising rates at least two more times this year. For the most part, bond yields seem to have settled into a new trading range, although the risk remains that US yields will drift higher. As long as the European Central Bank and the Bank of Japan continue with quantitative easing programs a sharp rise in yields is highly unlikely.

As expected, the Bank of Canada left the overnight rate unchanged in January. Without any clarity on US policy, Governor Poloz has no choice but to patiently wait for the impact on the Canadian economy to unfold. If US policy severely curtails Canadian exports, the Bank of Canada might need to utilize monetary stimulus while the economy adjusts to a new reality. Should this scenario unfold, a significant drop in interest rates would occur.

Regards,
The Algonquin Team

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“The more I practice, the luckier I get.”
Arnold Palmer

We grow up learning that success is the product of hard work and skill. What often gets overlooked is the role that luck can play; a factor that some economists believe has become increasingly important in our globalized, winner-take-all marketplace.

Effort and talent are certainly prerequisites for success, but with so many hard working and highly skilled individuals competing for the prize, the ‘ big winners’ are often also the luckiest. Take, for example, the world of sports, where a fortuitous bounce can be the difference between a champion and the ‘first loser.’

How much influence luck has depends on the endeavour you are pursuing.

At one extreme there is the lottery, requiring minimal ability and a ‘helluva’ lot of good fortune. On the other end of the spectrum, we have running and chess. It doesn’t matter how lucky you are; it’s highly unlikely that you’re beating Usain Bolt in a 100m dash or Kasparov at his game.

In between these two poles are the pursuits involving varying degrees of effort, ability, and providence. Take, for instance, poker; where with the right cards an amateur can take a few hands off a world champion. But over several hands or games, we would expect the professional’s expertise to win out.

While the champ can use her skill to dominate the amateurs, she better hope to have lady luck on her side at the final table. With so many highly skilled and evenly matched players, a good break can easily be the thing that leads to the final pot. This phenomenon has been dubbed ‘the paradox of skill’; the more highly trained and equally skilled the competition, the bigger fortune’s influence.

Like poker, investing is full of probabilities and uncontrollable factors. Also like poker, the outcomes are definitive and quantifiable, and in the short term can be determined by chance. Fortunately, investing is not a ‘point in time’ competition with clear winners and losers. Instead, it is a process where results should be measured over a longer period. Hard work, consistency of analysis, patience and discipline are key to moving an investment further away from a lottery and closer to a game of chess.

It is, therefore, the investor’s task to untangle luck from skill, to focus on the process rather than the immediate outcome. Unfortunately, this is a rather difficult proposition. We are naturally wired to seek out and link causes and effects, even where chance has been at play. The media is always ready to feed this desire, with a tidy story to explain every market move. And after something has occurred, a good narrative can make it seem as if what happened was always inevitable. Adding further static to the feedback loop is our inclination to assign luck the blame when things go wrong and ignore it when they go our way.

While difficult, separating luck and skill is a worthwhile endeavour, as it helps us to identify where our energy should be focussed. When skill is the dominant factor, as in golf, deliberate practice is the key. Where luck is involved, the focus should be on process and probabilities over results.

As an added bonus, studies have shown that those who can identify luck in their lives tend to be more grateful, likable and happier. We therefore not only wish you good luck for the year ahead but also the wisdom to recognize it.

The Fund

The ‘Trump Bump’ continued into December. New issues were dominated by banks; however, notable deals we participated in included Fairfax, Inter-Pipeline and Fortis. As some issuers pushed transactions into 2017, portfolio managers continued to pick away at secondary product, forcing credit spreads narrower. The fund benefited from a high exposure to credit and from the performance of the new deals to produce a monthly return of 1.62%, bringing the full year result to 23.15%.

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

In a nutshell, 2016 was a wild year for credit. After gapping wider 30 or 40 bps in January, credit spreads staged a remarkable recovery and ended, on average, 35 to 45 bps narrower on the year. Oil & Gas and Pipelines were the best performers while Retail underperformed largely due to Sobeys.

Looking ahead, domestic new issuance for 2017 is estimated to be between $85 – 95B. In the near term, the technical picture and investor sentiment support a modest narrowing of credit spreads. With the ‘policy-by-twitter’ strategy of President-elect Trump, we expect a fair degree of market volatility which should make for attractive trading opportunities.

Rates

Governors Poloz and Yellen certainly have their hands full. Dr. Yellen will have to guide US monetary policy amidst a potentially significant fiscal boost from the GOP. Given an already tight labour market, US core inflation ought to drift higher, allowing the Federal Reserve to tighten two or three times. As the sky didn’t fall after the first two hikes, the next couple should easily be digested by the markets.

Governor Poloz has greater challenges in store. Elevated housing prices and household indebtedness remain major risk factors for consideration. The uncertainty surrounding NAFTA, looming across-the-board tax cuts in the US, and the recent rise in Canadian bond yields likely mean the Bank of Canada will remain on hold for quite a bit longer. Perhaps Canadians will get ‘lucky’ and enjoy a much stronger economy given higher oil prices and improving growth across the world.

Regards,
The Algonquin Team

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“You don’t need a weatherman to know which way the wind blows.”
Bob Dylan

As the world tries to figure out what to expect from a Trump presidency, it appears the market has reached its conclusion. With US 10y bond yields up 0.60% in November, the expectation is for stronger growth and higher rates.

Investors, shocked with losses of 2% in their fixed income portfolios, have been wondering what happened and what’s next?

To answer these questions let us begin by looking in the rear view mirror. Historically, government debt has yielded 1% to 2% above inflation. When US 10 year notes traded at 1.75%, one could assume that people expected changes in consumer prices to be roughly zero for a decade. This seemingly bold bet suddenly appeared to be a silly one, prompting people to hit the sell button.

What drove the panic selling?

The anticipation of a substantial supply of new bonds and inflation.

As the Dylan song goes, “Come senators, congressmen, please heed the call.” With Republican’s in full control of US policy, the door is open to significant tax cuts and infrastructure spending. Since such policies would need to be financed with an abundance of debt, investors are rightfully demanding a higher return as compensation.

Donald and friends have also raised the inflation spectre. With US unemployment at 4.9% and a tough stance on illegal immigrants, there may be a limited amount of labour to meet the demand created by fiscal stimulus. This could lead to a substantial rise in wages to attract employees.

Further stoking the inflationary flames is the potential for a trade war. There have been forecasts showing that the imposition of 15% tariffs on Mexico and China could add 1% to US consumer prices.

This combination of rising wages and prices would push the Federal Reserve to steadily hike rates through 2017, forcing bond prices lower. As long as the promise of fiscal stimulus remains, US yields will likely remain under upward pressure. The path won’t necessarily be a straight one; however, it does seem that the ‘bottom’ is in.

What about O Canada, our home and native land?

Unlike the Federal Reserve, we expect the Bank of Canada to remain on the sidelines for the foreseeable future. This will keep short end rates anchored, but longer-dated yields have to adjust higher in sympathy with the US in order to entice global investors.

So how much higher will Canadian interest rates go?

To answer this, we revert back to our trusty rear view mirror. The Bank of Canada has successfully managed to keep inflation at roughly 2% for the last 25 years. Assuming history is a reasonable guide and rates normalize, one can expect 5 and 10 year yields to reach somewhere between 2.5% and 4%. These levels are more than double today’s yields, meaning more losses from traditional fixed income could be on the way.

How long will it take for rates to reach these levels?

‘The answer, my friend, is blowin’ in the wind.
The answer is blowin’ in the wind.’

The Fund

Given the uncertainty heading into the election, we significantly reduced our risk posture by liquidating most of our lower rated securities and hedging the portfolio with a selection of short positions. As the election results poured in and Dow futures plunged 800 points, we were happy to have gotten out of the way and wished we had put on a bigger hedge. The rapidity with which the market stormed back completely caught us off guard. As a result, we elected to ‘sit on our hands’ for a couple of days and watch.

After concluding the “the Trump bump” had legs, we aggressively increased the fund’s risk posture, including adding to bank NVCC and midstream energy positions. NVCC performed well on the speculation that less regulation and a lower cost of business will boost bank profits. Our energy exposure also performed well, with the last remaining position benefiting from a fortuitous bounce when OPEC decided to cut production.

Having hedged against the rise in interest rates and capitalized on the narrowing of credit spreads, the fund generated a return of 1.60% in November.

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

December is typically a favourable month for credit since new issue supply is often light. The issuance calendar seems abnormally empty as it appears that very few corporations need to borrow money, especially those rated BBB. Without a clear reason to worry about credit spreads, we continue to maintain a reasonable posture heading into the holiday season.

Rates

It is a foregone conclusion that the Federal Reserve raises rates on December 14th. The only unknown is their outlook for future hikes. The Bank of Canada, noting significant slack in the economy, will remain on hold for quite some time. Because interest rates ought to remain volatile, we will maintain tight hedges on the portfolio.

Regards,
The Algonquin Team

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“The man who reads nothing at all is better educated than the man
who reads nothing but newspapers.”
Thomas Jefferson

Every day we are bombarded with a barrage of news, delivered to us at breakneck speed. In theory, all this access to information should leave us more informed and better equipped to make decisions. But as the Trump campaign has reminded us, theory and practice are two very different animals.

Take for example the research done by psychologist Paul Andreassen in the late 1980s. In his experiments, investors without access to financial media earned higher returns than those that did. The group following the news closely was guilty of overtrading and overreacting to the latest headlines, thus impairing performance.

Fast-forward to today and some argue that the information overload is just too much. And in the pursuit of speed and brevity, veracity and quality have been sacrificed. Whether you ascribe to these theories or not, the reality is that it’s very difficult to get an accurate view of the world through headlines. This is because the media is limited to reporting what happens and what is newsworthy. We have yet to see a special report on a company performing as expected or another peaceful day in the city.

This is why, as Newt Gingrich put it, people ‘feel’ the world is a more violent and unsafe place despite the facts indicating otherwise. As sociologist Barry Glasner notes: “Between 1990 and 1998, the murder rate in the United States decreased by 20 percent. During that same period, the number of stories about murder on network newscasts increased by 600 percent.”

Similarly, ask anyone what they think is a more likely cause of death, shark attacks or lightning strikes. They will probably be shocked to learn that it is lightning and by a factor of 30 to 75 times. With a little analytical thinking this makes sense. Shark attacks can only occur on the coast, whereas lightning can strike anywhere. But sharks make for exciting stories and great movies, making them easier to recall.

On top of delivering us the news, the media also like to trot out expert panels to opine on everything from the price of oil to tomorrow’s hockey game. Not only are there many studies showing how simple algorithms can provide better predictions than the experts, but there is also evidence that media fame reduces the accuracy of their forecasts. This is usually attributed to overconfidence and the need for these personalities to have extreme and definitive views. After all, nobody is tuning in to hear that the price of oil could be between $30 and $70 next year or that their team has 50/50 chance of winning.

At the end of the day, we must remember that it’s not the media’s job to make us better investors and voters. They get paid for clicks and eyeballs. Sadly, sound financial advice and deep political analysis are boring, repetitive and don’t always fit in 140 characters or less. We will keep this in mind no matter who becomes the 45th US president.

The Fund

Heading into October, we were quite concerned with the hype surrounding Deutsche Bank and opted for a fairly conservative posture. When Deutsche was able to find buyers for $4.5B of 5-year senior unsecured bonds, the markets calmed considerably. We reacted quickly to re-establish positions exited in September, generally at cheaper levels. In particular, we took advantage of the widening that had occurred in bank and insurance subordinated debt to enter at favourable prices.

After the OPEC production cut on September 27th, oil prices started firming. We stepped back into one of our favourite names in the oil space and bought CNQ bonds. This position performed extremely well, generating 10% of the monthly return. With Deutsche Bank off the radar and a lower-than-anticipated new issue supply, credit spreads generally narrowed. This coupled with the carry led to October’s solid performance of 1.86%.

Since Inception: 38.19%

Credit

If new issue supply remains light, credit spreads ought to grind narrower in November. The lack of investment grade product is putting portfolio managers in a real “damned if you do, damned if you don’t” situation. Those who reduce exposure now, risk not being able to buy corporate bonds should Clinton prevail. If Trump is president, given the market’s disdain for uncertainty and his views on NAFTA, the potential for a “sell Canada” trade to materialize is a real possibility.

Positioning portfolios ahead of next week’s election will be a tricky proposition. The key will be to maintain as much flexibility as possible to react after the event. As such and because of the asymmetric risk/reward profile, we have chosen to err on the side of caution and position the portfolio more conservatively.

Rates

The press has made a lot of noise about yields moving higher, and indeed it has been a lousy month for bond holders. However, fixed income funds are still up approximately 4% on the year. Investors are becoming a little more nervous that the ECB and BoJ won’t increase their quantitative easing programs. Furthermore, it appears that the Chinese economy may be stabilizing, which in turn could lead to higher growth in other parts of the world. The drift to modestly higher yields may continue as people adjust their economic expectations.

The Bank of Canada has managed to confuse people with their language around the prospects of another rate cut. After the dust had settled, expectations gravitated back to the Bank doing nothing for many more months. The Federal Reserve continues to prepare everyone for a rate hike. Barring an unexpected data disaster (and yes, President Trump may qualify) we expect the Federal Reserve to hike rates 25 bps in December.

Regards,
The Algonquin Team

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