Sunday, 23 April 2017

Toronto House Price Boom: How Will It End?

Last year it was Vancouver house prices. This year it is the Toronto housing "crisis" that has politicians panicking. In March, the average Toronto house price was up 33% over a year ago. This news sparked a meeting of "three wise men" -- Canada's Finance Minister Bill Morneau, Ontario's Finance Minister Charles Sousa, and Toronto's Mayor John Tory -- to collaborate on appropriate actions to ease the panic. 

The three wise men agreed that they should refrain from adopting policies which would add to already overheated demand. Then within days, Ontario's Liberal government announced a "suite" of measures to respond to what they claimed was a public clamour for government intervention. Premier Kathleen Wynne and Mr. Sousa, not wanting to let a good crisis go to waste, seized the opportunity to impose a new 15% tax on non-resident buyers and tighten housing regulation in the worst possible way by imposing strict rent controls. Unfortunately, such actions that are more likely to worsen rather than improve the fundamental problem of insufficient supply of reasonably priced housing. 

I am returning to the issue of housing prices after writing about it in March, 2014 in Why So Paranoid About Canada's Housing Market, and again in June 2016 in China Stimulus and Vancouver House Prices

In March 2014, I argued that, while some high profile commentators thought Canada was in the midst of a housing bubble that was on the verge of bursting, my research showed that Canada's housing prices were still good value relative to house prices in other countries and that there was no reason to think that a Canadian house price bubble was about to burst. Looking back, that view proved correct. Far from bursting, house prices in Vancouver, in Toronto and in several other Ontario cities have since soared a further 50% or more.

In June 2016, after Vancouver house prices had shot up over 50% in just three years, I acknowledged that they had entered bubble territory. I pointed to the effect of spillovers from China's aggressive easing of monetary policy on house prices in cities in China and also in cities such as Vancouver and Toronto that are attractive to Chinese investors. I argued, "It is the job of Finance Minister Morneau, along with provincial and city officials, to decide what measures might curb the influence of foreign central bank stimulus on Vancouver and Toronto house prices and how these measures might be applied without bringing about [a] sharp house price correction". In July 2016, Vancouver introduced a 15% Foreign Buyer Tax. In November, the city followed up with a 1% annual tax on the assessed value of vacant houses. Vancouver home sales fell immediately following the introduction of the Foreign Home Buyers tax and prices experienced a moderate setback for a six months before starting to climb again recently.

Toronto's House Price Booms Sometimes End Badly

To read the local newspapers, you would think that Toronto house prices have never boomed before. There are widespread complaints that available housing data are insufficient to determine the causes of the recent rapid price appreciation. But it's not hard to find data that shows that Toronto has been here before. The chart below shows several measures of Toronto house prices dating back to 1969.

The data goes back furthest for the Toronto Real Estate Board average house price (TREB AHP). Also shown are Statistics Canada's Toronto New House Price Index (NHPI) and, more recently, the Multiple Listing Service Toronto House Price Index (MLS HPI) and the Teranet Toronto House Price Index. While the quality of some of these measures is better than others, all of them tell basically the same story. There have been three house price booms in the past five decades in which annual increases reached double digits for consecutive years and peaked at 30% or more.

The first episode, in 1974-75, saw average house prices rise 25% and 30% in consecutive years. In the second episode, in 1986-89, prices rose consecutively by 27%, 36%, 21% and 19%. In the current boom, 2015-17, average prices are on track to rise 15%, 20% and over 30% consecutively.

After the 1974-75 boom, price increases slowed sharply. After the much bigger 1986-89 boom, prices collapsed. The chart below uses the same data as above, but expresses it as drawdowns in prices from their previous peak.

What is clear from this chart is that the drawdown following the 1989 peak was by far the worst house price decline experienced in fifty years. Prices for both new and existing homes fell over 25% and did not hit bottom until 1996, seven years after the boom peaked.

How Did Previous House Price Booms End?

In 1974-75, the boom was ended by a North American recession triggered by the first oil price shock. House prices gains slowed markedly, but there was no crash. Unfortunately, at the peak of house price and rent increases in the runup to the 1975 Ontario provincial election, Premier Bill Davis succumbed to political pressure to invoke strict rent controls. Vince Brescia, past CEO of the Federation of Rental Housing Providers of Ontario describes the outcome:
The results were devastating. Rental housing supply screeched to a halt, vacancy rates quickly began to drop, rents began to rise and tenants couldn’t find apartments. Investors all pulled out of Ontario rentals; they could not operate under a system that incented owners to cut back on investment and let the buildings deteriorate.
The bust in the housing market that followed the 1974-75 boom was concentrated in the collapse of rental housing construction that dragged on for over twenty years and greatly curtailed both the quality and  availability of affordable housing in Toronto. 

The 1986-89 boom, the biggest Toronto house price surge of the past 50 years, was ended by a combination of rising mortgage rates, a short-lived oil price spike brought on by Iraq's invasion of Kuwait, and another North American recession. After the huge boom, prices plunged and would not recover to their 1989 peak until 2002. Toronto suffered through a lengthy house price deflation in the 1990s. 

Eventually, with the election of Conservative Premier Mike Harris on his "Common Sense Revolution" platform, rent controls ended in 1998 on buildings constructed after 1991. This move launched more than a decade of strong construction activity of both privately-owned and rental housing in Toronto that has changed the face of the city. 

How Will the Current Boom End?

The current Toronto house price boom is more pronounced than that of 1974-75 but less pronounced and extended than that of 1986-89. The chart below shows the three booms, with the start date set when annual house price gains exceeded 10% on a sustained basis. The horizontal axis shows the number of months from the start of the boom. The prices are in real terms (i.e. deflated by the CPI) to make them comparable.

The chart shows that the current boom has just about matched the 1973-75 boom in duration (at 33 months vs. 36) and that cumulative real price appreciation since the start of the boom has been 55%, about 12% more than at the peak of the 1973-75 boom. However, the current boom has not yet come close to matching the 1985-89 boom in either duration or cumulative real price appreciation. 

This implies that the current boom could go on for more than another year and prices could rise by a further 30% without exceeding the 1985-89 boom. However, that may seem unlikely because governments are already taking active steps to cool the market. 

The current boom bears more similarities to 1973-75, not only in duration and magnitude, but also in the types of government action taken to cool the boom, influenced by political pressure on an Ontario Premier ahead of a provincial election.

When the two previous booms ended real house prices fell. After the 1975 peak, real prices fell 12% over the next six years. Following the 1989 peak, real prices fell 35% over the next six years. Housing starts also went from boom to bust after the housing price peaks, as shown in the chart below. Following both the 1975 and 1989 peaks, housing starts plunged by more than 40% compared with their level at the start of the price boom.

The current boom lies in between its' predecessors. If we are seeing the peak now, it might be reasonable to expect real prices to decline 15-20% over the next six years. However, as occurred following the 1975 peak, construction of rental housing is likely to fall dramatically and the availability of affordable housing is unlikely to grow. 

Of course, if the current boom continues for another year and another 30% price appreciation, it would look more like the 1989 peak. In that event, a deep, long house price recession would become likely and future real prices might then be expected to decline something like 30-35% from the peak.  

Some may say that Toronto house prices will never decline. But they have in the past. Ben Bernanke famously said in July 2005, "We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize." That seems to be the hope of the three wise men. But Toronto's history clearly demonstrates that there is a good chance that, like its two predecessors, this boom will end badly.


Tuesday, 11 April 2017

What's Happening Inside Canada's Labour Market

Canadian economists were quite upbeat on the March labour market report. Headlines from the major  banks carried a common theme: 

  • "Canadian Jobs March On" (CIBC) 
  • "The Beat Goes On" (BMO), and 
  • "Canada’s job gains beat expectations again!" (RBC)
Sounds pretty good. But even as the economists purred over the job gains, they noted that wage growth was still quite soft. The reports, as per usual, focused on the minutiae of month-to-month changes in employment across different industries and among full-time and part-time workers, many of which were not statistically significant. It's rare for economists who face the daily grind of reporting on every economic indicator to step back and look at underlying trends inside the labour market. But doing so helps explain some seeming anomalies and overall paints a less rosy picture of labour market.

Hours Worked Tell a Different Story

While employment was up 1.5% in 1Q17 on a year-over-year basis, total hours worked by those employees at their main job was actually down 0.1% (even with a sizeable jump in hours worked in March). Main jobs are the source of the vast majority of Canadians income from work. Some, who cannot make a living wage at their main job, take on second or third jobs to supplement their incomes. Apparently, more people have had to take on extra jobs over the past year, as total hours worked at all jobs were up 1.4% in 1Q17.

When we look at hours worked on main jobs by industry, we find that several key industries with high-paying jobs have seen substantial declines in hours worked, while other industries with low-paying jobs have seen increases in hours worked, as shown in the chart below.

The biggest declines in hours worked over the past year have been in the resource sector, especially in the oil and gas industry. Manufacturing, construction and utilities have also seen substantial declines.  Large employers like health and social services and education have seen small declines. At the other end of the spectrum, decent gains in hours worked have occurred in accommodation and food services, transportation and warehousing, business services (which includes waste management) and finance, insurance and real estate. By far the largest gain in hours worked over the past year has been in public services (i.e. federal, provincial and municipal governments).

When one sees these changes in hours worked, it becomes much less of a mystery why wage growth has been weak. According to Statistics Canada's Labour Force Survey, the average hourly wage earned by employees at their main job was C$26.12 in 1Q17. But some industries paid much higher (or lower) hourly wages than the average, as shown in the chart below.

The resource sector, which experienced the biggest decline in hours worked, was the industry with one of the highest average hourly wage rates, over $13 per hour higher than the Canadian average. The utilities, construction, and education industries, which also pay above average wages all saw declines in hours worked. In contrast, the accommodation and food services industry, which pays the lowest average hourly wage -- $11/hr below the national average and $24/hr less than the resource sector -- was one of the industries which saw a meaningful gain in hours worked. The wholesale and retail trade, transportation and warehousing, and business services sectors, which pay below average wages, also saw increases in hours worked. The one anomaly is the public sector, where hourly wages are high and hours worked posted the largest increase of any sector.

It seems clear that Canada is experiencing decent total job growth, but that total hours worked for employee's main jobs have been flat, with high-wage industries reducing hours worked, low-wage industries increasing hours worked. This is not a sign of a healthy labour market.

Why is this happening?

If I had to come up with a story to explain the labour market developments of the past year, it would go like this. The collapse in the world price of oil, which began in mid-2014, resulted in a dramatic declines in hours worked in Canada's resource sector in 2015 and 2016. Declines in energy-related activities spilled over into the non-residential construction, utilities and manufacturing industries. These declines were probably magnified by a tightening of environmental regulations which stalled pipeline construction and carbon tax proposals by governments concerned with global warming. With weakness in key sectors of the economy and new left-of-centre governments in Ottawa and some provinces, hours worked in governments shot up. The sharp weakening in Canada's former industrial growth drivers triggered two 25 basis point policy rate cuts in 2015 and a 20% depreciation of the Canadian dollar relative to the USD. With interest rates falling to rock-bottom levels and the currency cheapening, housing prices in Canada's most cosmopolitan cities -- Vancouver and Toronto --  became extremely attractive to both foreign and domestic purchasers and the real estate industry boomed as the house price bubble inflated. The weakening of the currency made foreign travel more expensive for Canadians, while at the same time making travel to Canada less expensive for foreigners, benefitting the transportation, accommodation and food service industries.        

So, while many economists look at Canada's job gains over the past year through rose-coloured glasses, I see the changes occurring in Canada's labour market as signs of weakness in the the Canadian economy. More Canadians are forced to work multiple jobs to make a decent living. High-paying jobs are harder to find. Employment gains are concentrated not in a thriving private sector, but in low paying industries benefitting from a cheap currency, in a bubbly and unsustainable real estate sector, and in activist, meddlesome governments. 

Monday, 3 April 2017

Trump Trade Evolves: Global ETFs Portfolios for Canadian Investors

The first quarter of 2017 is in the books, so it's time to review the performance of our global ETF portfolios. The quarter kicked off with the inauguration of President Trump and ended with the Trump Administration's failure to win passage of a bill to repeal and replace Obamacare in the House of Representatives dominated by his Republican Party. 

Against this background, a Canadian stay-at-home investor who invested 60% of her funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 1Q17 total return (including reinvested dividend and interest payments) of 1.7% in Canadian dollars. Had that investor diversified her portfolio to the global ETFs that are tracked in this blog, her returns would have been as much as twice that high. 

The weaker performance of the all-Canadian portfolio continues a trend that began with the election of Donald Trump as US President. However, the leading global ETF performers evolved in interesting ways in 1Q17 that reflected, in part, the markets' changing assessment of Trump's ability to implement his election promises. 

Global Market ETFs: Performance for 1Q17

The chart below shows 1Q17 returns, including reinvested dividends, in Canadian dollars (CAD), for the ETFs tracked in this blog. The returns are shown for the period from the US election in November through the end of 2016 (blue bars) and for 1Q17 (green bars). As the CAD appreciated 1.1% against USD, two of the best global ETF performers were Emerging Market equities (EEM) and Gold (GLD), each of which suffered big losses in the immediate aftermath of Trump's win. The worst performer in 1Q17 was the Commodities ETF, which had posted sharp gains immediately following the election. 

Global ETF returns were mostly positive across the different asset classes in 1Q17. In CAD terms, 17 of 19 ETFs posted gains, while just 2 posted losses. 

The best gains were in the the Emerging Market Equity ETF (EEM) which returned a strong 11.3%. The Eurozone Equity ETF (FEZ) was second best, returning 7.7% in CAD terms, followed by the Gold ETF (GLD), which returned 7.1% in CAD. Other solid gainers included the S&P500 ETF (SPY), the Japan Equity ETF (EWJ), and Emerging Market Local Currency Bonds. 

The worst performers were the Commodities ETF (GSG) which returned -6.5% and the Canadian Real Return Bond ETF (XRB) which returned -1.6%.

Global ETF Portfolio Performance for 1Q17

In 1Q17, the global ETF portfolios tracked in this blog posted solid returns in CAD terms. However, as with the performance of individual ETFs noted above, the performance of of the various portfolios evolved significantly in 1Q17 versus that of the immediate post election period, as shown in the chart below.

A simple Canada only 60% equity/40% Bond Portfolio returned 1.7%, as mentioned at the top of this post. While solid, the 1Q17 return was weaker than the all-Canada portfolio achieved in the period immediately following the US election and also weaker than the returns on the global ETF portfolios.

Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 3.6% in CAD terms, continuing its strong performance in late 2016 and making it the best performing portfolio since the election. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned 2.8% in 1Q17, about the same gain it enjoyed in the immediate post election period.

A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 2.8% in CAD terms. This was a remarkable improvement over the return of -0.17% in the immediate post election period, as bonds and foreign currencies performed significantly better in 1Q17. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, returned 2.5%, also a significant improvement over the immediate post election period.

Key Events of 1Q17

In my view, the main events that left a mark on Canadian portfolio returns in 1Q17 were President Trump's setbacks and delays in implementing his election promises; the decision by the US Fed hike its policy rate more quickly than markets had expected; and stronger-than-expected growth of DM economies outside the US. 

Trump's setback on Obamacare, as well as the successful court challenges to his executive order temporarily banning immigration from certain countries, demonstrated both legislative and judicial obstacles to implementation of some of his election promises. Markets had cheered his promises to reduce regulation and cut taxes. He has made headway on cutting regulation but the setback on Obamacare has raised doubts about his ability to get controversial elements of tax reform through Congress. In addition, Trump has not yet followed through on his protectionist election promises targeting Mexico and China which had hammered Emerging Market stocks and currencies in the immediate aftermath of the election.  

The Fed's decision to hike in March dampened bond prices, especially for longer term bonds. Meanwhile, stronger-than expected growth in the Eurozone, Japan and Canada helped boost equity returns outside the US.   

Looking Ahead

At the beginning of 2017, I said that the most interesting question, in my mind, was whether the all-Canada 60/40 ETF portfolio would outperform the unhedged global ETF portfolios as it did in 2016. The answer, so far, is that since the election of Donald Trump the all-Canadian portfolio has returned to the pattern of the past five years, in which it lagged the performance of the global ETFs portfolios by a wide margin.

Three months ago, I said that answer to the question would be determined in part by the behaviour of commodity prices, the Bank of Canada and the Canadian dollar. Commodity prices which were expected to firm modestly, have fallen. The Bank of Canada has so far remained in no hurry to begin raising its' policy rate, even as the Fed hiked in March, sooner than expected. Despite weakness in commodity prices and a dovish BoC, the Canadian dollar, which was expected to weaken moderately against the USD, actually appreciated by over 1%. Upward revisions to expectations for Canadian GDP growth along with President Trump's limited success, so far, in implementing his policy promises has weighed on US dollar sentiment and helped lift the Canadian dollar. 

If Trump's plans continue to be thwarted or watered down by Congress, the trends of 1Q17 may be expected to continue. Emerging market equities, bonds, and currencies, which sold off in the immediate post-election period on fears of Trump's promises of protectionist policies, have further room to rally.  

The main risk to that outlook is that President Trump, stung by his early setbacks, redoubles his efforts on protectionist trade policies and tax reform, including some form of border tax.

Friday, 13 January 2017

Canadian Horror Story: Trump's Border Tax

Toyota Motor said will build a new plant in Baja, Mexico, to build Corolla cars for U.S. NO WAY! Build plant in U.S. or pay big border tax. (@realDonaldTrump)

With this tweet on January 5, President-elect Donald Trump got the attention of not only of Toyota and Mexico, but also a few astute Canadians. The realization began to dawn on them that Trump's promise to "Rip up NAFTA" was not the only threat to jobs and investment in Canada. Some may have even realized that the "big border tax", if adopted, could turn out to be a bigger concern than a renegotiation of NAFTA, which the Trudeau government was already contemplating.

One of these astute Canadians, Daniel Schwanen, international trade specialist and Vice-President of Research at the C.D. Howe Institute, when questioned about the border tax by the Globe and Mail, said: 
On its face, this proposal is devastating. This could really hurt trade and millions of workers in Canada.

How Did Trump Dream Up the Border Tax?

The so-called border tax is not a trade policy. It is a part of a sweeping corporate tax reform that did not originate with Donald Trump, but with Paul Ryan, the Republican Speaker of the US House of Representatives and Kevin Brady, Chair of the House Ways and Means Committee, as unveiled in their “A Better Way” plan last June. As pointed out by Dylan Mathews on, the Ryan-Brady plan,    
includes a big cut in the tax rate, from 35 percent to 20 percent. But it also includes some huge changes in the way the corporate tax works... They want to make it impossible for companies to deduct interest payments on loans... They want to make big capital investments totally deductible in the year they’re made rather than “depreciable” over time... But perhaps most dramatically of all, they want to allow companies to totally exclude revenue from exports when calculating their tax burden, and to ban them from deducting the cost of imports they purchase. 

Think of how this change would affect US companies that purchase imported goods from Canada (or elsewhere) either as inputs to their own production or for final sales to US consumers. Currently, such imports are a deductible business expense when calculating US corporate taxes. Under the Ryan-Brady plan, the cost of imported goods would not be deductible. The cost of inputs purchased from US domestic companies would be deductible from US corporate tax, providing a huge cost advantage to sourcing inputs from within the United States rather than from abroad. On balance, the result of the corporate tax reform would be equivalent to imposing a 20% tariff on imports from Canada (and other countries). 

Now think of how the change would affect US companies that export to Canada where they compete with Canadian companies. The US companies would no longer have to pay any corporate tax on their export revenues. As a result, US companies would either see a large increase in their profit margins on exports or they could cut their prices, thereby forcing Canadian companies to do the same. But Canadian companies would still have to pay Canadian corporate taxes on their revenues.

This would be a horror story for Canada (and Mexico and other major US trading partners). The table below shows Canada's exports to and imports from the United States.

Based on 2015 data, the latest year available, the border tax would be assessed on C$367 billion of Canadian exports to the US.  Canada's export-oriented industries  energy, motor vehicles and parts, minerals and metals, and forest products  would be placed at a big competitive disadvantage relative to US-based competitors. At the same time, C$285 billion of US exports to Canada would not be subject to US corporate tax. Canada’s import competing industries – food products, machinery and equipment and other consumer goods – would face much stiffer competition from US exporters that would not have to pay corporate tax.

How US Economists View the Border Tax

Such sweeping US tax changes may seem radical, but they have support from respectable US economists including Alan Auerback of Berkeley, who has long been a proponent of the border tax, and Martin Feldstein of Harvard, who wrote in an op-ed piece endorsing the idea in the Wall Street Journal on January 5, the same day Trump tweeted about the border tax.

Feldstein explains the new border tax with some simple examples. Here is one, with my additions to make the consequences clear for Canada shown in brackets:

A U.S. importer that pays $100 to import a product [from Canada] can, if there is no border tax adjustment, sell that product to a U.S. retail customer for $100. But with the border tax adjustment, the $100 import cost is not deductible from the corporate tax base. The price to the U.S. retail buyer would have to be $125, of which $25 would go toward the 20% tax... This calculation makes it look as if the border tax adjustment causes the U.S. consumer to pay 25% more for [imports from Canada]. But the price changes that I have described would never happen in practice because the [US] dollar's international value would automatically rise by enough to eliminate the increased cost of imports... With a 20% corporate tax rate, that means that the value of the [US] dollar must rise by 25%. [This means that the US dollar would have to rise to 1.67 Canadian dollars from 1.33 currently, meaning that the Canadian dollar would need to drop to 60 US cents]. The rise of the dollar relative to foreign currencies means that the real purchasing power of foreigners declines to the extent that they import products from the United States or sell products to the U.S.

Feldstein explained his view that the US dollar would strengthen quickly to offset the impact of higher import prices for US consumers at this link on Bloomberg TV. You can judge for yourself whether you believe exchange rates would move as Marty asserts. He also asserted that the border tax would raise US$120 billion per year relative to the current corporate tax with the tax burden being borne by US trade partners.  

Not all US economists support the border tax idea. Lawrence Summers, former Treasury Secretary in the Clinton Administration and therefore not likely to have may sway with Trump, wrote this in an op-ed in the Washington Post on January 9:

[T]he tax change would likely harm the global economy in ways that reverberate back to the United States. It would be seen by other countries and the World Trade Organization as a protectionist act that violates U.S. treaty obligations. While proponents argue that such an approach should be legal because it would be like a value-added tax, the WTO has been clear that income taxes cannot discriminate to favor exports. While the WTO process would grind on, protectionist responses by others would be licensed immediately. Moreover, proponents of the plan anticipate a rise in the dollar by an amount equal to the 15 to 20 percent tax rate. This would do huge damage to dollar debtors all over the world and provoke financial crises in some emerging markets. Because U.S. foreign assets are mostly held in foreign currencies whereas debts are largely in dollars, U.S. losses with even a partial appreciation would be in the trillions.

What Could Canada Do?

Trump's apparent adoption of the border tax as a tailor-made solution to his election promises to Make America Great Again and to bring back manufacturing jobs to the United States should be the top concern for Canada's new Foreign Affairs Minister Chrystia Freeland and for Finance Minister Bill Morneau. Prime Minister Justin Trudeau, who is busy right now engaging with ordinary Canadians in coffee shops across the country, needs to be briefed.

It is less clear what Canada could do about it, if President Trump and the Republican Congress get on board with the border tax. During the Nixon Administration, when the US slapped on a (short-lived) 10% import surcharge, the Pierre Trudeau government sent its envoys to Washington to seek an exemption, but none was given. Obtaining an exemption from a US corporate tax reform would be a tall order even for a government on good terms with the US Administration. Presumably, Canada would need to adopt a similar corporate tax framework to that of the US and seek to have Canadian produced goods treated the same as US produced goods for corporate tax purposes in both countries. That would take a lot of doing.

Another alternative would be to join together with other US trade partners and challenge the border tax at the World Trade Organization. As Larry Summers points out, while the WTO process grinds on, disruption of trade with the US would be severe and retaliation by some US trade partners would be likely.

A final alternative would be to grin and bear it and accede to Marty Feldstein's solution of letting the Canadian dollar weaken about 20% further against the US dollar to keep our exports from getting priced out of the US market. This would mean a further large hit to Canadian's purchasing power and tacit agreement by Canadians to bear part the cost of reducing the US fiscal deficit.

Monday, 9 January 2017

Global ETF Portfolios: 2016 Returns for Canadian Investors

Last year I started my annual review of portfolio returns by saying; “2015 was a lousy year for Canadian investors”. Well, 2016 was a turnaround year as the Canadian dollar strengthened modestly and Canadian equities rebounded strongly.

A stay-at-home 60/40 investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a 2016 total return (including reinvested dividend and interest payments) of 13.9% in Canadian dollars, a dramatic improvement from the 3.1% loss generated by the same portfolio in 2015. The Canadian dollar strengthened 2.8% against the US dollar, so the all Canadian 60/40 Portfolio had a 2016 total return of 17.2% in US dollar terms, a substantial recovery from the 19% loss in USD terms in 2015.

The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavor, we track various portfolios made up of different combinations of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios. 

Since we began monitoring these portfolios at the end of 2011, we have found that the Global ETF portfolios have all vastly outperformed a simple stay-at-home portfolio. In 2016, we saw a reversal of this trend.

Global Market ETFs: Performance for 2016

In 2016, with the CAD appreciating almost 3% against USD and 8% against EUR, the best global ETF returns for Canadian investors were in Canadian equities and US small cap equities. The worst returns were in Eurozone bonds and equities and US Treasury bonds. The chart below shows 2016 returns, including reinvested dividends, in CAD terms, for the ETFs tracked in this blog. The returns are shown for the full year (green bars) and for the period following the election of Donald Trump as President in October (blue bars).

Global ETF returns varied widely across the different asset classes in 2016. In CAD terms, 15 of 19 ETFs posted gains, while just 4 posted losses. 

The best gains were in the Canadian equity ETF (XIU) which returned a robust 21.2%. The US Small Cap Equity ETF (IWM) was second best, returning 18.2% in CAD terms, followed by the US High Yield Bond ETF (HYG), which returned 10.3% in CAD. Other decent gainers included the S&P500 ETF (SPY), the Emerging Market Equity ETF (EEM), the commodity ETF (GSG), and Emerging Market Bonds, both USD-denominated (EMB) and local currency denominated (EMLC). 

The worst performers were the Non-US Government Bond ETF (BWX), the Long-term (10-20yr) US Treasury Bond (TLH), Eurozone Equities (FEZ), and Japanese Equities (EWJ).

Global ETF Portfolio Performance for 2016

In 2016, the global ETF portfolios tracked in this blog posted decent returns in CAD terms when USD currency exposure was left unhedged and stronger returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.

A simple Canada only 60% equity/40% Bond Portfolio returned 13.9%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 6.0% in CAD terms when USD exposure was left unhedged, but 7.7% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 7.4% if unhedged, and 8.8% if USD hedged.

Risk balanced portfolios performed similarly in 2016 if unhedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a 6.1% in CAD terms if USD-unhedged, but had a strong return of 10.9% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, returned 7.4% if USD-unhedged, but 9.8% if USD-hedged.

Four Key Events of 2016

In my view, there were four key policy events that left a mark on Canadian portfolio returns in 2016. The first was the Bank of Canada's decision not to cut the policy rate in January. The second was the US Fed's decision to delay its decision to hike the US policy rate until December. The third was the Brexit vote. The fourth was the unexpected election of Donald Trump. The impact of each of these four events can be seen in the chart below which tracks weekly portfolio returns over the course of 2016. 

The Bank of Canada's decision not to validate market expectations which leaned toward a January rate cut, provided a boost for the Canadian dollar but weakened returns on unhedged global portfolios. The Fed’s decision to delay hiking the US policy rate in response to weak first half real GDP growth kept the Canadian dollar on a strengthening path until mid-May, when the Fort McMurray forest fires caused a stumble in Canadian growth and a weakening of CAD. The Brexit vote on June 23 triggered a brief pullback in global equity markets and, combined with the introduction of negative policy rates in the Eurozone and Japan, saw global bond yields fall to their low for the year. This combination saw a period of outperformance by risk balanced portfolios with heavier allocations to fixed income.  

The US election (along with a strengthening in global economic data) triggered a US-led rally in equity markets. US equity ETFs, especially the Small Cap ETF (IWM), performed best after the election, along with the commodity ETF. The US dollar gained ground against all currencies, including the Canadian dollar. Bonds sold off sharply everywhere. As a result, equity-heavy (and bond-light) portfolios performed best in the post-election period.

Looking Ahead (Through the Fog) 

As we enter 2017, the most interesting question, in my mind, is whether the all-Canada 60/40 ETF portfolio will continue to outperform the unhedged global ETF portfolios as it did in 2016. As the chart below shows, the 2016 outperformance was the first since we started tracking these portfolios at the end of 2011. 

Even taking 2016 into account, the Canada 60/40 portfolio has returned 6.3% per annum over the past five years, badly trailing the global portfolios, which have all returned between 9.6% and 10.2% per annum. A C$100 investment in the Canada 60/40 ETF portfolio at the end of 2011 would have risen in value to C$137 by the end of 2016, compared with C$158-163 for the four global ETF portfolios we track.

The answer to the question will be determined largely by the behaviour of commodity prices, the Bank of Canada and the Canadian dollar. Consensus expectations look for commodity prices to firm modestly, for the Bank of Canada to remain on hold even as the Fed hikes its policy rate by 75 basis points and for the Canadian dollar to weaken moderately against the USD. The consensus does not unambiguously favor either the all-Canada or the global portfolios. The best plan seems to be to wait, to watch and to react as economic and policy uncertainty gives way to more clarity.        

Tuesday, 3 January 2017

2017 Economic Outlook: Consensus and Other Views

It's time to look ahead to global macro prospects for 2017. I have posted similar outlooks for the past three years and followed up at the end of each year with an assessment of those forecasts. I assemble consensus views for the year ahead on global growth, inflation, interest rate and exchange rate outlooks which are presumably already built into market prices. The consensus view, as Howard Marks says, is "usually unhelpful at best and wrong at worst". What will move markets in 2017 is not the current consensus forecast, but the ways in which actual economic developments diverge from that consensus.

The big surprises of 2016 – Brexit, the impeachment of President Dilma Roussef in Brazil, and the election of Donald Trump as President – will have significant economic impacts in 2017 and beyond. 

The US equity market, as well as those of several other countries, has responded positively to Trump’s election. Investors have essentially placed bets that Trump’s early moves will focus on reducing taxes and regulations and that his campaign rhetoric about ripping up trade deals and deporting millions of illegal immigrants will proceed with caution.

Many high profile economists – Krugman, Roach, and Rosenberg – are warning of much more pessimistic outcomes (some of these views seem quite partisan). Some warnings take Trump’s election rhetoric on trade and immigration at face value. Others are based on the notion that Congress will not actually implement many of Trump's election promises.

Despite the market’s optimistic response and the aforementioned economists’ warnings, economic the consensus forecast has barely changed since before the US election. I do not think that means the election outcome will have little effect on economic and financial market performance in 2017 and beyond. I think it means that forecasters are a bit like deer in the headlights, not knowing yet which way to jump. The consensus remains unchanged as some forecasters shade their views in favor of the market’s optimism and others shade theirs in favor of the more pessimistic view. As I said in my review of 2016 forecasts last month, “2017 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. As an era of rising asset values supercharged by ever-easier unconventional monetary policies seems to be coming to an end, the scope for new surprises to cause dramatic market moves has perhaps never been higher”.

With the foregoing in mind, here is what the consensus view is telling us about 2017:

  • Global real GDP growth is expected to be modestly stronger than 2016;
  • Global inflation is expected to be higher than in 2016;
  • The Fed is expected to hike the Fed Funds rate by 75 basis points, while other DM central banks are mostly expected to hold their policy rates steady and some EM central banks are expected to lower rates;
  • In the DM, 10-year government bond yields are expected to rise in the US, UK and Eurozone, but be little changed in Japan, Canada and Australia; In the EM, 10-year yields are expected to rise modestly in Brazil, Russia and Korea, but to fall in India, China and Mexico.
  • After strengthening against most of the currencies we track in 2016, the US dollar is expected to turn in a more mixed performance. Views of individual currency forecasters for 2017 exhibit much more dispersion than forecasts for other economic variables, but when averaged into a consensus view, most currencies are expected to move less than 2% against the USD. This seems like a very unlikely outcome. But for what it’s worth, the USD is expected to strengthen by the end of 2016 against RBL, BRL, CNY and CAD and to weaken against GBP, EUR, JPY, AUD, and MXN.
  • After strong performances in 2016, equity strategists tell us that US and Canadian stock markets are expected to post more modest gains of about 6% and 4%, respectively.

This year’s growth forecasts are notably more conservative than last year’s, as economists belatedly turn more cautious after several years of growth disappointing to the downside. Inflation once again is expected to move higher but, with the exception of the Fed, central banks are not expected to respond to higher inflation by tightening policy. 

Global Real GDP Growth Forecasts

Last year at this time, global growth was expected by the IMF to pick up to 3.5% in 2016 from 3.1% in 2015. Economists at five large global commercial bank expected a more modest acceleration to 3.4%. Instead, global growth is now estimated to have slowed to 3.0% in 2016.

This year, forecasters tell us once again that global growth will pick up in 2017 to 3.4% (IMF October forecast), or to 3.3% (OECD November forecast and the December average of global commercial bank forecasts).

Real GDP growth in 2017 is expected to be stronger in many economies, but with the notable exceptions of the Eurozone, UK, China, Korea and Mexico. Economies with the largest forecast growth pickups include India (7.3% in 2017 vs 6.7% in 2016), Canada (1.8% vs 1.3%), US (2.0% vs 1.6%), Japan (1.3% vs 1.0%), and Australia (2.7% vs 2.4%),. 

While global growth is expected to be stronger in 2017, an important divergence between DM and EM growth performance is expected to continue. EM growth is consistently higher than DM growth, but the important divergence is that, for a third consecutive year, DM economies (with the exception of the UK) are expected to grow at or above their trend rate of growth, while most EM economies (with the exception of India) are expected to grow below their trend rate. In the chart below, the blue bars show the 2017 consensus growth forecast versus the OECD estimate of the trend growth rate for each economy.

In 2017 the Eurozone and Japan are expected to grow at an above trend pace, while the UK – dealing with Brexit uncertainty – is expected to grow well below trend. In contrast, four of the larger EM economies are expected to grow well below trend: Mexico (1.0% below trend), Russia (0.9% below trend), Brazil (0.7% below trend) and China (0.5% below trend). 

In the chart above, the red bars show the latest OECD composite leading indicators (CLIs) versus trend for each of the economies. Unlike in the past two years, these CLIs generally support stronger 2017 growth than economists are forecasting, with a few exceptions.

In the DM economies, the leading indicators suggest that growth could surprise on the strong side in the Eurozone and Canada but on the downside in the US and Japan. In the EM economies, CLIs suggest that growth could be stronger than expected in Brazil, India, Russia and Korea but weaker than expected in China.

Global Inflation Forecasts

Global inflation has consistently fallen short of expectations since 2013. This occurred in spite of unprecedented efforts by central banks to fight disinflation.

A year ago, global inflation for the entire set of world economies was expected by the IMF to move up to 3.5% by the end of 2016 from 2.9% at the end of 2015. By October 2015, the IMF had cut its year-end 2016 global inflation forecast to 3.2%. Meanwhile, a year ago, global commercial bank economists expected weighted average inflation for 12 major economies we track to move up to 2.3% in 4Q16 from 2.0% in 4Q15. Instead, inflation for these countries remained flat at 2.0% in 4Q16. For 2017, the Bloomberg consensus of economists forecasts that weighted average inflation for the 12 countries will rise to 2.5% in 4Q17. The IMF and the OECD expect a slightly bigger acceleration for the 12 countries to 2.6%.

These forecasts, most of them made between mid-November and early-December, may already subject to upward revision. Crude oil prices ranged from $45 to $49 per barrel during the period these forecasts. Since then, in the wake of the December OPEC meeting, the price has risen to $54/bbl in late December and looks likely to maintain the higher price into early 2017.

In all of the DM economies we track, inflation is expected to rise. In EM economies the picture is more mixed, with inflation expected to fall in Brazil and Russia, where currencies have strengthened markedly over the past year. In Mexico and China, where currencies have weakened, inflation is expected to rise. Considerable slack remains in the global economy, especially in EM economies. But wage growth is picking up in some countries. Commodity prices are rising. Inflation expectations are rising.

Non-Consensus Views

As already mentioned, some economists, who are not part of the consensus, have a much darker view of 2016 prospects. Paul Krugman and Stephen Roach warn that Trump will set off trade wars with China, Mexico and other US trade partners. Krugman says, “Will this cause a global recession? Probably not … What the coming trade war will do is cause a lot of disruption … and quite a few American manufacturing operations would end up being big losers.”

Russell Napier sees a different problem with the consensus: 
The consensus may be bullish on the USD exchange rate and while consensus is regularly wrong, on this occasion it might be wrong because it is not bullish enough! 

Napier argues that “the USD has much, much further to rise” and that this will present a particularly difficult environment for China, which is also one of the major targets of Trump’s protectionist rhetoric. Rising US interest rates have spilled over globally and have aggravated China’s capital flight and accelerated the decline in China’s foreign exchange reserves. Napier suggests that it is “time for China to grow up and run an independent monetary policy choosing the appropriate price or supply or money without reference to the level of the exchange rate.” A strengthening USD and a depreciating CNY are “turning the deflationary screws on the global economy. It will likely be up to the Fed to stop the rise of the US dollar, but what ammunition is at its disposal, particularly if the President’s fiscal policy is indeed stoking domestic inflation?”

David Rosenberg graciously offered up a free year-end piece, which the Globe and Mail ran with the headline: "Forget inflation - here's what really will happen in 2017". The headline is a bit misleading because Rosenberg, quite reasonably, says “I actually find it senseless to provide a forecast for the entire year ahead at this time”. While declining to provide a forecast, Rosenberg is pretty sure about one thing: “I do have as strong view that inflation very much is going to be the non-event it has for the past several decades”. Rosenberg provides several good reasons why Trump’s platform will be disinflationary. Although bond yields will be volatile over the course of 2017, Rosenberg thinks that as inflation fears abate, the 10-year US Treasury yield will fall and "close the year around 2%", about 70 basis points lower than the consensus forecast. 

Another non-consensus view is that of Wall Street’s number one ranked strategist, Francois Trahan, Head of Portfolio Strategy at Cornerstone Macro. In this video Trahan goes against the consensus with a view that the equity bull market is almost over and it’s time to get defensive. He makes this argument partly on the assumption that Congress will not pass all of Trump’s pro-growth policies and their effect will be delayed but, more importantly, because US monetary policy is tightening, global financial conditions are tightening, and growth is about to slow significantly. He argues that macro policy forces already in the pipeline will outweigh anything Trump does in 2017 and the result will be lower US corporate earnings and a lower P/E ratio, so that the slowdown will have a disproportional impact of equity prices. Trahan expects US data to weaken in 1H17 after a burst of strength in late 2016. The result will be a significant correction and possibly a bear market in equities. I have to give Trahan credit; he has the conviction to go against the frozen Wall Street consensus.   

I'm not suggesting that we should toss out the consensus forecast; it provides a useful benchmark against which to measure the coming surprises of 2017. But, as with other non-consensus analysts, I am suggesting that once again we should apply a hefty discount rate to the consensus and consider the risks around a wide range of possible optimistic and pessimistic scenarios. 

Questions and Conclusions

2016 turned out to be another year in which global growth and inflation were both modestly disappointing and the political surprises were widely viewed in a negative light. Risk assets nevertheless performed very well. The legacy of the political surprises of 2016 is policy uncertainty for 2017. Some of the unanswered questions include: 

  • How will the UK and the EU handle Brexit? And will other EU countries follow the UK's lead? 
  • Which of Trump’s election promises will be implemented and when? 
  • How will US trading partners respond to Trump’s protectionism? 
  • How will global markets react and adjust to expected Fed tightening? 
  • Will the expected continued strengthening of the US dollar combined with below trend growth in China, Brazil and Russia create financial instability and continue to exert global deflationary pressures? 

At the moment, I would be quite suspicious of the advice being offered by many investment strategists. Those who have been long the growth trade and have benefited from the “Trump rally” in equity markets are suggesting stay with the trade in the near term but be flexible and prepared to exit should the recent optimism be blunted by disappointments. Those strategists who went into the US election in a defensive position and remain skeptical that Trump’s policies can “Make America Great Again” are suggesting maintaining larger than normal cash positions which may be deployed when risk assets correct sometime in 2017. 

In 2017, I’m afraid, we are on our own.
Ted Carmichael is Founding Partner of Ted Carmichael Global Macro. Previously, he held positions as Chief Canadian Economist with JP Morgan Canada and Managing Director, Global Macro Portfolio, OMERS Capital Markets. 

Monday, 12 December 2016

The Biggest Global Macro Misses of 2016

As the year comes to a close, it is time to review how the macro consensus forecasts for 2016 that were made a year ago fared. Each December, I compile consensus economic and financial market forecasts for the year ahead. When the year comes to a close, I take a look back at the prognostications and compare them with what we know actually occurred. I do this because markets generally do a good job of pricing in consensus views, but then move --  sometimes dramatically --  when the consensus is surprised and a different outcome transpires. When we look back, with 20/20 hindsight, we can see what the surprises were and interpret the market movements the surprises generated.  

Of course, the biggest forecast misses of 2016 were not in the economic indicators and financial markets, but in the political arena. The consensus views of political pollsters were that Brits would vote to remain in the European Union and that Hilary Clinton would win the US Presidential election. Instead, the actual outcomes were Brexit and President-elect Donald Trump. These political misses have had and will continue to have significant economic and financial market consequences. In the context of these political surprises, it's not only interesting to look back at the notable global macro misses and the biggest forecast errors of the past year, it also helps us to understand 2016 investment returns.

Real GDP

Since the Great Financial Crisis, forecasters have tended to be over-optimistic in their real GDP forecasts. That was true again in 2016. Average real GDP growth for the twelve countries we monitor is now expected to be 3.0% compared with a consensus forecast of 3.5%. In the twelve economies, real GDP growth fell short of forecasters' expectations in eleven and exceeded expectations in just one. The weighted mean absolute forecast error for 2016 was 0.51 percentage points, down a bit from the 2015 error, but still sizeable relative to the actual growth rate.

Based on current estimates, 2016 real GDP growth for the US fell short of the December 2015 consensus by 0.8 percentage points, a bigger downside miss than in 2015 (-0.5) or 2014 (-0.1). The biggest downside misses for 2016 were for Russia (-1.6 pct pts), Brazil (-1.4), India (-1.1) and Mexico (-0.8). China's real GDP  beat forecasts by 0.1. Canadian forecasters missed by -0.5 pct pts, a little less than the average miss. On balance, it was a sixth consecutive year of global growth trailing expectations.

CPI Inflation

Inflation forecasts for 2016 were also, once again, too high. Average inflation for the twelve countries is now expected to be 2.2% compared with a consensus forecast of 2.6%. Nine of the twelve economies are on track for lower inflation than forecast, while inflation was higher than expected in three countries. The weighted mean absolute forecast error for 2016 for the 12 countries was 0.33 percentage points, a much lower average miss than in the previous two years.

The biggest downside misses on inflation were in Russia (-0.9 pct pts), India (-0.7), Australia (-0.7), and Korea (-0.6). The biggest upside miss on inflation was in China (+0.5). UK and US inflation were also slightly higher than forecast.

Policy Rates

Economists' forecasts of central bank policy rates for the end of 2016 once again anticipated too much tightening by developed market (DM) central banks, but for emerging market (EM) central banks, it was a more mixed picture.

In the DM, the Fed failed to tighten as much as forecasters expected. The biggest DM policy rate miss was in the UK, where the Bank of England had been expected to tighten, but instead cut the policy rate after the Brexit vote. The ECB, the Bank of Japan, the Reserve Bank of Australia and the Bank of Canada also unexpectedly cut their policy rates. In the EM, the picture was more mixed. In China, where inflation was higher than expected, the PBoC did not deliver expected easing. In Brazil and India, where inflation fell more than expected, the central banks eased more than expected. In Russia where inflation also fell, Russia's central bank eased less than expected. In Mexico, where the central bank was expected to tighten, the tightening was much greater than expected after the Trump election victory caused the Mexican Peso to fall sharply.

10-year Bond Yields

In nine of the twelve economies, 10-year bond yield forecasts made one year ago were too high. Weaker than expected growth and inflation combined with major central banks’ decisions to delay tightening or to ease further pulled 10-year yields down in most countries compared with forecasts of rising yields made a year ago.

In five of the six DM economies that we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.33 percentage points. The biggest misses were in the UK (-0.88 pct. pt.), Eurozone (proxied by Germany, -0.49), Japan (-0.39), and Canada (-0.34). In the EM, bond yields were lower than forecast where inflation fell more than expected, in India and Russia. The biggest miss in the bond market was in Brazil, where inflation fell much more than expected and reduced political uncertainty saw the 10-year bond yield almost 4 percentage points lower than forecast. Bond yields were higher than expected in China, where inflation was higher than expected, and much higher than expected in Mexico where political risk increased with Trump's election.

Exchange Rates

Currency moves against the US dollar were quite mixed in 2016.  The weighted mean absolute forecast error for the 11 currencies versus the USD was 5.4% versus the forecast made a year ago, a smaller error than in the previous two years.

The USD was expected to strengthen because many forecasters believed the Fed would tighten two or three times in 2016. Once again the Fed found various reasons to delay, with only one tightening occurring on December 14. If everything else had been as expected, the Fed's delay would have tended to weaken the USD. But everything else was not as expected. Most other DM central banks eased policy by more than expected and the ECB and the BoJ implemented negative policy rates. In addition, oil and other commodity prices rallied causing commodity currencies like RUB, AUD, and CAD to strengthen more than forecast.

The biggest FX forecast misses were casualties of the big political consensus misses on Brexit and the US presidential election. The GBP was almost 18 percent weaker than forecast a year ago, while the MXN was 17% weaker than forecast after President-elect Trump promised to “tear up” NAFTA. The biggest miss on the upside was for BRL (+27%) where President Dilma Rousseff’s impeachment received a standing ovation from the currency market.

North American Stock Markets

A year ago, equity strategists were optimistic that North American stock markets would turn in a decent, if unspectacular, performance in 2016. However, despite a year characterized by weaker-than-expected real GDP growth and inflation and by political surprises that were widely-perceived as negative, North American equity performance exceeded expectations by a substantial margin. I could only compile consensus equity market forecasts for the US and Canada. News outlets gather such year-end forecasts from high profile US strategists and Canadian bank-owned dealers. As shown below, those forecasts called for 2016 gains of 5.5% for the S&P500 and 10.0% for the S&PTSX Composite.

As of December 14, 2016, the S&P500, was up 13.6% year-to-date (not including dividends) for an error of +8.1 percentage points. The S&PTSX300, rebounding from a sizeable decline in 2015, was up 17.1% for an error of +7.1 percentage points.

Globally, actual stock market performance was less impressive than that of North American markets, with two notable exceptions, Russia and Brazil. 

Stocks performed poorly the Eurozone and Japan, where deflation worries caused central banks to adopt negative interest rates. China saw the biggest equity loss (-11.3%) of the markets we monitor as slowing growth and fears of currency devaluation fueled large capital outflows. In the US, where the Fed delayed monetary policy tightening, and in the UK, where the BoE unexpectedly eased, equities posted solid gains. In Canada, and Australia, where central banks eased more than expected, equities were also boosted by a recovery in commodity prices. Russia and Brazil posted huge equity market gains, rebounding from large currency and equity market declines in 2015.

Investment Implications

While the 2016 global macro forecast misses were similar in direction, they were generally smaller in magnitude relative to those of 2015 and the investment implications were different. Global nominal GDP growth was once again weaker than expected, reflecting downside forecast errors on both real GDP growth and inflation. In 2016, most central banks either tightened less than expected or eased more than expected, but continued political uncertainty, weaker than expected nominal GDP growth and the strong US dollar held the US equity market in check through early November prior to the US election. 

Although many strategists argued that a Trump victory would be bad for US equities, because of uncertainty over his policies in general and his protectionist views in particular, the opposite reaction followed the election. US equities outperformed by a wide margin. US small caps and financials led the gains on Trump’s promise of reduced regulation, corporate tax reform and a steeper yield curve. UK equities rallied in the aftermath of Brexit, boosted by the increased competitiveness generated by the sharp depreciation of the GBP. In Japan and the Eurozone, where governments failed to enact structural reforms and where central banks experimented with negative policy interest rates, equities badly underperformed. In Canada, Australia, Brazil, Mexico and Russia, rebounding commodity prices supported equity markets. In China, one of the few countries where reported nominal GDP growth was stronger than expected (despite on-the-ground reports of economic slowdown), equity prices fell as capital fled the country.

Similar to the previous two years, downside misses on growth and inflation and central bank ease in most countries provided solid, positive returns on DM government bonds in the first 10 months of 2016. However, after the Trump election victory, as markets priced in stronger US growth and inflation and bigger US budget deficits, government bonds across the globe gave back much of their gains and significantly underperformed equities in all regions.

Smaller divergences in growth, inflation and central bank responses, along with firming crude oil and other commodity prices, led to smaller currency forecast errors. For Canadian investors, the stronger than expected 5% appreciation of CAD against the USD meant that returns on investments in both equities and government bonds denominated in US dollars were reduced if the USD currency exposure was left unhedged. The biggest losers for Canadian investors were Eurozone and Chinese equities, as well as most DM sovereign bonds, especially if unhedged.

As 2017 economic and financial market forecasts are rolled out, it is worth reflecting that such forecasts form a very uncertain basis for year-ahead investment strategies. The high hopes (and fears) that markets are currently pricing in for a Trump presidency will surely be recalibrated against actual policy changes and foreign governments’ policy reactions. 

The lengthy period in recent years of outperformance by portfolios for Canadian investors that are globally diversified, risk-balanced and currency unhedged may have run its course. Global asset performance may be shifting toward a more US-centric growth profile that could also benefit Canada if Trump’s protectionist tendencies are implemented only against China, Mexico and any other countries a Trump-led America deems to unfair traders. While such an outcome is possible, 2017 will undoubtedly once again see some large consensus forecast misses, as new surprises arise. As an era of rising asset values supercharged by ever-easier unconventional monetary policies seems to be coming to an end, the scope for new surprises to cause dramatic market moves has perhaps never been higher.