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.

Saturday, 12 November 2016

Global Macro Reaction to President Trump

To the surprise of many, it's President Trump. 

In the days ahead of the election, global equities sold off when Donald Trump narrowed Hillary Clinton's lead in the polls after the FBI reopened the investigation into Hillary's emails. After the FBI announced that there were no grounds to prosecute on the Sunday before the election, global equities rallied as pollsters raised their odds of a Clinton victory. 

On election night, when it became evident that Trump might win the election, Asian equity markets fell and Dow futures plunged almost 800 points. After his conciliatory acceptance speech, equity futures recovered and, after opening lower on Wednesday morning, the US equity market began a strong three day rally that was not expected.

This post looks at the early reaction of global markets to the Trump victory through the lens of the global ETFs that we normally track.

US Equity ETF's Biggest Winners, EM Assets Biggest Losers

The chart below shows the returns on global ETFs, from the close on election day, November 8 (before results were known), until the close on Friday, November 11.  

The returns are shown both in USD terms and in CAD terms, which are of interest to Canadian investors. The USD gained 1.9% versus CAD from the close on November 8 to the close on November 11, thereby pushing up CAD returns on USD-denominated ETFs.

In USD terms, US equities were the only ETFs that posted gains after the Trump win. The biggest gainer among the ETFs we track in this blog was the US small-cap equity ETF (IWM) which gained 7.1% in USD terms and 9.2% in CAD terms.  The US large-cap equity ETF (SPY) gained 1.0% in USD terms and 3.0% in CAD.

Other global equity ETFs didn't fare as well. The emerging market equity ETF (EEM) posted a large loss, with Canadian (XIU), Eurozone (FEZ) and Japanese (EWJ) equities posting more modest losses in USD terms.

The biggest losers were emerging market ETFs, led by the emerging market local currency bond ETF (EMLC) -8.7% in USD terms, the emerging market equity ETF (EEM) -7.8%, and the emerging market US dollar bond ETF (EMB) -5.7%. 

All other asset class ETFs posted losses.  In commodities, the gold ETF (GLD) was down 3.7% in USD terms, while the commodity ETF (GSG) was down 2.0%, as oil price declines outweighed gains in copper and other metals. In sovereign bonds, Canadian (XLB), US (TLH) and non-US (BWX) bond ETFs all lost 3-4% in USD terms. US (TIP) and Canadian (XRB) inflation-linked bonds outperformed their sovereign counterparts, but not by much, and the non-US inflation linked bond ETF (WIP) underperformed its sovereign counterpart. Corporate bond ETFs also posted losses, as US investment grade (LQD), US high yield (HYG) and Canadian investment grade (XCB) all posted losses of 2-3% in US terms.

While US equities performed best, it is interesting to look at little deeper into equity returns as shown in the chart below, which looks at some other equity sector and country ETFs.

The chart shows that when looked at by sector and by country, there were some much bigger winners and losers. The US bank stock ETF (KBE) gained 11.5% in USD and 13.6% in CAD. The US defence and aerospace (ITA) and health care (IYH) ETFs also both outperformed the S&P500 by a wide margin, while the technology ETF (IYW) posted a loss of 1.1% in USD. As for country or regional equity ETFs, the Mexico (EWW) and China (MCHI) equity ETFs were big losers, down 17.9% and 4.8% respectively in USD terms. Interestingly, the Russia ETF was one of the few gainers. The EAFE (EFA) and Canada (EWC) equity ETFs were more modest losers. 

Interpreting the Global Macro Message from the Markets

The reaction of global asset markets aligns reasonably well with the policy priorities of President-elect Trump. These priorities (in no particular order) seem to be:

  • Repeal/replace Obamacare
  • Increase spending on infrastructure and defence
  • Reject the Paris Agreement on climate change 
  • Reform and cut taxes
  • Reduce regulation of banks and other industries
  • Tear up NAFTA, reject TPP, raise tariffs on Chinese and Mexican imports
  • Tighten immigration, deport (some) illegal immigrants

The anticipated positive effects on US small business profitability of repealing Obamacare, reduced red tape, lower taxes, and reduced competition from Mexico and China triggered the outsized gains in US small-cap equites (IWM). US large-cap equities also gained, but significantly underperformed small-caps, as large global companies face a more mixed picture as they depend more on global trade and supply chains than do small-caps.

The anticipated fiscal stimulus reflected in plans for lower taxes and increased infrastructure and defence spending is likely to boost both growth and fiscal deficits in the short term. The market reacted by lifting defence and construction equipment stocks and by selling off US Treasury bonds.

With fiscal policy taking the lead in boosting growth, US monetary policy will likely move more quickly to normalize the policy rate and be less likely in the future to resort to unconventional policy measures, including quantitative easing and negative policy rates. As a result, markets are signalling an expectation that bond yields will continue to rise from record lows. 

Tightening immigration and deporting illegal immigrants is likely to reduce labor supply in an already tight US labor market, thereby adding to wage pressures. Raising tariffs and rejecting or weakening free trade agreements will put further upward pressure on inflation, more bad news for bond ETFs. 

Anticipation of rising interest rates, a steepening yield curve, and talk of repeal of (some of) the Dodd-Frank bank regulations imposed following the financial crisis, provided a huge boost to US bank ETFs.

Trump's plans to raise tariffs and reject or renegotiate trade deals, is clearly bad news for countries dependent on trade with the United States, including Mexico, Canada and China. It is also bad news for US industries which have developed major supply chains in these countries, including the US technology and auto industries.

The intention to reject the Paris Agreement on climate change will free US energy producers from concerns about possible emissions targets or carbon taxes and encourage greater US oil and coal production. It will also likely lead to reduced subsidies and other incentives for technology companies pursuing green energy projects.

Global asset markets have adjusted swiftly to a changed set of expectations is the wake of the election of Donald Trump. Details of his policies remain unknown, but the market clearly senses, and already reflects, the broad strokes of President-elect Trump's policy priorities. What remains to be seen, is how quickly and how fully his campaign promises will be implemented.

Tuesday, 4 October 2016

Global Monetary Spillovers and Bank of Canada Independence

In a recent post, I discussed The Breakdown of Faith in Unconventional Monetary Policy. Zero interest rate policy (ZIRP), quantitative easing (QE), forward guidance on policy rates and, more recently, negative interest rate policy (NIRP) have been undertaken in various forms and to varying degrees by the four major DM central banks, the US Federal Reserve (Fed), the European Central Bank (ECB), the Bank of Japan (BoJ) and the Bank of England (BoE). Some smaller central banks have dabbled in unconventional monetary policies (UMPs), including the Swiss, Danish and Swedish central banks. 

But, from the perspective of other countries, where the domestic central banks have not been aggressive participants in UMP, the important question is how do these policies affect their economies, their financial markets and the independence of their monetary policies. Recent research has focused on the global spillovers from UMPs of the major central banks into the monetary policies and financial conditions of other global economies, especially EM economies and some of the small open DM economies. This research has found strong evidence that UMP has spilled over into other economies, complicating the conduct of national monetary policies and, at times, creating risks to financial stability.

Evidence of Spillovers

In a their paper, International Monetary SpilloversBoris Hofmann and Előd Takáts of the Bank for International Settlements (BIS) state that:
We find economically and statistically significant spillovers from the United States to EMEs [emerging market economies] and smaller advanced economies [including Canada]. These spillovers are present not only in short- and long-term interest rates but also in policy rates. In other words, we find that interest rates in the United States affect interest rates elsewhere beyond what similarities in business cycles or global risk factors would justify. We also find that monetary spillovers take place under both fixed and floating exchange rate regimes.

Jaime Caruana, General Manager of the BIS, in a recent paper entitled, The international monetary and financial system: eliminating the blind spot, makes the following observation:
Most central banks target domestic inflation and let their currencies float, or follow policies consistent with managed or fixed exchange rates in line with domestic policy goals. Most central banks interpret their mandate exclusively in domestic terms. … [L]iquidity conditions often spill over across borders and can amplify domestic imbalances to the point of instability. In other words, the international monetary and financial system as we know it today not only does not constrain the build-up of financial imbalances, it also does not make it easy for national authorities to see these imbalances coming. 
Moreover, the search for a framework that can satisfactorily integrate the links between financial stability and monetary policy is still work in progress with some way to go. The development and adoption of such a framework represent one of the most significant and difficult challenges for the central bank community over the next few years. 
Caruana has identified four channels by which global liquidity conditions can spill over:

  1. through the conduct of monetary policy: easy monetary conditions in the major advanced economies spread to the rest of the world via policy reactions in the other economies (e.g., easing to resist currency appreciation and maintain competitiveness);
  2. through the international use of currencies: most notably, the domains of the US dollar and the euro extend so broadly beyond their respective domestic jurisdictions that US and euro area monetary policies immediately affect financial conditions in the rest of the world. … A key observation in this context is that US dollar credit to non-bank borrowers outside the United States has reached $9.2 trillion, and this stock expands on US monetary easing;
  3. through the integration of financial markets, which allows global common factors to move bond and equity prices. Uncertainty and risk aversion, as reflected in indicators such as the VIX index, affect asset markets and credit flows everywhere; and 
  4. through the availability of external finance in general, regardless of currency: capital flows provide a source of funding that can amplify domestic credit booms and busts. In the run-up to the global financial crisis, for instance, cross-border bank lending contributed to raising credit-to-GDP ratios in a number of economies.

Caruana concludes:
Through these channels, monetary and financial regimes can interact with and reinforce each other, sometimes amplifying domestic imbalances to the point of instability. Global liquidity surges and collapses as a result. What I have just described is the spillovers and feedbacks – and the tendency to create a global easing bias – with monetary accommodation at the centre. But these channels can also work in the opposite direction, amplifying financial tightening when policy rates in the centre begin to rise, or even seem ready to rise – as suggested by the taper tantrum of 2013.

Implications of Spillovers for Canada

For smaller, open DM economies like Canada, the spillovers from the major central banks’ UMPs are readily visible. 

When the major central banks lowered their policy rates to near zero, the Bank of Canada (BoC) did likewise. This was partly driven by concerns about domestic economic weakness and partly to resist appreciation of the Canadian dollar and the resulting loss of competitiveness. When the BoC became concerned about what proved to be a temporary increase in inflation and raised its policy rate in 2011, the Canadian dollar appreciated strongly.

When major central banks engaged in Quantitative Easing, through large-scale purchases of their own sovereign debt, demand for close substitutes like Canadian sovereign debt increased and forced down Canadian long term government bond yields.

When major central banks, including the Bank of Japan, ECB and BoE moved to NIRP, the Bank of Canada announced that its research showed that it, too, could lower its policy rate below zero if necessary.  

The net result is that Bank of Canada policy has become both constrained by and heavily influenced by the UMPs of the major central banks. Canadian liquidity and financial conditions reflect not just the BoC’s policy rate setting, but also and more importantly, the extraordinarily accommodative policies of the major central banks. The BoC has had no choice but to keep its policy rate low. Failing to do so would have created even greater exchange rate appreciation that would have stunted growth even more and pushed inflation even further below the 2% target.

The ultra-low interest rates imported through global financial markets, have led to a credit boom. The credit boom has been characterized by heavy borrowing by Canadian households and some sectors of Canadian business, such as the energy sector. 

The heavy mortgage borrowing by households has contributed to overheated housing markets in Vancouver and Toronto. As I have argued in a previous post, the housing boom in these cities was amplified by easy credit policy by the People's Bank of China (PBoC), which saw synchronized housing price surges in large Chinese and Canadian cities. With inflation below target and the BoC unable to raise its policy rate to quell this overheating, federal, provincial and municipal governments have intervened with macro-prudential policies, such as tighter mortgage rules, the recent tax on foreign homebuyers in Vancouver, and the federal government's closing of the capital gains tax loophole for foreign homebuyers.

When energy prices were high, supported by near-zero policy rates and the liquidity boost provided by quantitative easing by the major central banks, Canadian energy companies issued large amounts of corporate debt at low rates. When the surge in global investment in fracking technology spurred strong growth in energy supply at a time of lacklustre demand growth, energy prices collapsed and default rates jumped sharply in the energy sector. 

The integration of global financial markets means that global uncertainty and risk aversion is instantly transmitted to Canadian markets for stocks and bonds. Canadian markets and asset prices are now as sensitive, if not more sensitive, to changes in policies of the major central banks as they are to changes in Bank of Canada policy.

Monetary Spillovers and Central Bank Independence

This raises the important question of whether the central banks of smaller open economies, like Canada, can pursue independent monetary policy.

Canada's Nobel Prize winning economist, Robert Mundell, laid the groundwork with what he referred to as "the impossible trinity" and what others have called the "monetary trilemma". As explained by Paul Krugman in 1999,

Mundell proposed the concept of the "impossible trinity"; free capital movement, a fixed exchange rate, and an effective monetary policy. The point is that you can't have it all: A country must pick two out of three. It can fix its exchange rate without emasculating its central bank, but only by maintaining controls on capital flows (like China today); it can leave capital movement free but retain monetary autonomy, but only by letting the exchange rate fluctuate (like Britain--or Canada); or it can choose to leave capital free and stabilize the currency, but only by abandoning any ability to adjust interest rates to fight inflation or recession.

Wikipedia summarizes with the help of the diagram below: "The Impossible Trinity" or "The Trilemma", in which two policy positions are possible. If a nation were to adopt position a, for example, then it would maintain a fixed exchange rate and allow free capital flows, the consequence of which would be loss of monetary sovereignty.

When Canada let its exchange rate float in 1970, it opted for position b on the chart, accepting the need for a flexible exchange rate because it wanted to maintain free international capital mobility and a sovereign (i.e., independent) monetary policy.

But global monetary policy spillovers now challenge the ability of smaller central banks to conduct an independent monetary policy, even if the central bank is prepared to maintain a flexible, market-determined exchange rate. 

In a paper entitled Dilemma not Trilemma: The Global Financial Cycle and Monetary Policy Independence, Hélène Rey of the Kansas City Fed argues,
[M]onetary policy [of] the center country [i.e. the major central banks] … affects leverage of global banks, credit flows and credit growth in the international financial system. This channel invalidates the "trilemma", which postulates that in a world of free capital mobility, independent monetary policies are feasible if and only if exchange rates are floating. Instead, while it is certainly true that countries with fixed exchange rates cannot have independent monetary policies in a world of free capital mobility, my analysis suggests that cross-border flows and leverage of global institutions transmit monetary conditions globally, even under floating exchange-rate regimes.

Implications for Canadian Monetary Policy 

At a minimum, it is high time that the Bank of Canada openly analyze and discuss with the public, the influence that the major central banks' unconventional monetary policies are having on the Canadian economy and financial markets.

How will the future paths of the major central banks policies influence and constrain the policies of the Bank of Canada?

With the Fed signalling that it plans to resume a gradual tightening of policy at a time when the Canadian economy is struggling to adjust to much lower prices for oil and other commodities, the likely spillover will be a premature and possibly excessive, tightening of Canadian financial conditions. Should the Bank of Canada keep pace with Fed tightening or hold the line on Canada’s policy rate and thereby encourage further depreciation of the Canadian dollar? Or should it cut its own policy rate to offset the spillover of tighter financial conditions arising from Fed tightening?

If Fed tightening pushes up global bond yields (and therefore Canadian mortgage rates) how should the BoC respond to the likely fallout in the Canadian housing market if housing prices experience a sharp correction? 

If US and global growth falters and the Fed returns to more aggressive use of UMP, including a zero or even negative Fed policy rate and a resumption of QE, can the BoC afford not to follow?

If the BoJ and/or the ECB push policy rates further into negative territory, should the Bank of Canada be prepared to follow?

If Japan adopts ‘helicopter money’ or central bank financed fiscal stimulus, should the BoC consider the same direction?

Is there any alternative to mimicking the unconventional policies of the major foreign central banks? If the answer is yes, then how will the tradeoffs between the interests of savers and borrowers and between the interests of exporters and domestic consumers be balanced? 

If the answer is no, then what remains of the independence of the BoC? If its' policy rate and Canadian bond yields reflect spillovers from foreign central bank UMPs can the BoC independently pursue its' 2% inflation target? Are its policies not then dominated by foreign central bank actions or possibly by its own government’s needs to finance new spending and hold down debt service costs through financial repression?

These are tough and important questions that are not even being discussed in Canada.

Sunday, 2 October 2016

Global ETF Portfolios for Canadian Investors: 3Q16

The stay-at-home strategy continued to perform well in 3Q16 after three years of underperforming the globally diversified ETF portfolios that we track in this blog. Crude oil prices finished September little changed from where they were at the end of June. The US Fed remained on hold but laid the groundwork for another tightening move before the end of the year. Meanwhile, the Bank of Canada stood pat and talked of rates staying low for long.

The price of WTI crude oil, which began the year at US$37 per barrel finished 3Q16 at US$48/bbl, virtually unchanged from the 2Q closing level. The BoC decision to stand pat, combined with the Fed continuing to signal one tightening before yearend, sparked a 1.6% depreciation in the Canadian dollar in 3Q, ending September at US 76.2 cents, down from 77.4 cents at the end of June.

Flat crude oil prices combined with the 1.6% depreciation in the Canadian dollar in 3Q16 provided modest headwinds for stay-at-home portfolios. Unhedged global ETF portfolios were able to outperform in a quarter when both stocks and bonds continued to rally. A stay-at-home 60/40 investor who invested 60% of their funds in the Canadian equity ETF (XIU), 30% in the Canadian bond ETF (XBB), and 10% in the Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of 4.0% in Canadian dollars. Most of the unhedged Global ETF portfolios that I track in this blog posted slightly stronger gains for 3Q16. Since we began monitoring at the beginning of 2012, the unhedged Global ETF portfolios have vastly outperformed the stay-at-home portfolio.

Global Market ETFs: Performance for 3Q16

In 3Q16, with central banks remaining dovish and the USD appreciating 1.6% against the CAD, global ETF returns favoured foreign equities. In CAD terms, 18 of the 19 ETFs we track posted positive returns, while just one ETF posted a loss for the quarter. The chart below shows 3Q16 returns (blue bars) and year-to-date returns (green bars), in CAD terms, including reinvested dividends, for the ETFs tracked in this blog.

The best gainers in 3Q16 were global equity ETFs, including Japan equities (EWJ) which returned 10.8% in CAD terms, followed closely by US small cap equities (IWM) at 10.7% and emerging market equities (EEM) at 10.2%. The best performing bond ETFs were US High Yield Bonds (HYG) which returned 6.1% in 3Q16, followed by non-US inflation-linked bonds (WIP)  at 5.4%. The Gold ETF (GLD) returned 1.0%. The worst performer was the commodity ETF (GSG) which returned -3.0% in CAD terms.

For 2016 year-to-date, the best performing ETFs in CAD terms were the gold ETF (GLD), the Canadian equity ETF (XIU), and the Canadian long bond ETF (XLB). The worst year-to-date performers were Eurozone equities (FEZ), commodities (GSG) and Japanese equities (EWJ).

Global ETF Portfolio Performance for 3Q16

In 3Q16, the Global ETF portfolios tracked in this blog all posted solid returns in CAD terms. This was true whether USD currency exposure was hedged or left unhedged, but the unhedged portfolios performed better, reversing the pattern of the previous two quarters.

A stay-at-home, Canada-only 60% equity/40% Bond Portfolio returned 4.0% in 3Q16. Among the global ETF portfolios that we track, risk balanced portfolios outperformed in 3Q16. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, benefitting from strong levered bond returns, gained 4.7% in CAD terms if unhedged, but had a lower return of 3.4% 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, gained 4.4% if unhedged and 3.2% if USD-hedged.

The Global 60% Equity/40% Bond ETF Portfolio (which includes both Canadian and global equity and bond ETFs) returned 4.4% in CAD terms when USD exposure was left unhedged, and 3.2% 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 3.9% if unhedged and 2.9% if USD hedged.

On a year-to-date basis, the all Canadian stay-at-home ETF portfolio remained the best performer, returning 10.7% ytd, outperforming all of the unhedged global ETF portfolios that we monitor in CAD terms. If USD exposures were hedged, however, the best performing portfolio was the Global Levered Risk Balanced Portfolio, which returned 15.0% in CAD terms.

Looking Ahead

The key market events of 2016 that have influenced global ETF portfolio returns in CAD terms were: the market's rising conviction that slow global growth and below-target inflation in the major DM economies will delay and moderate any tightening by the Fed and encourage further easing by other major central banks; the BoC's signalling that its policy rate will likely remain low for long; and a gradually improving balance between global demand and supply of crude oil. These events occurred against a backdrop of further downward revisions to global growth  and inflation expectations and rising political uncertainty as the UK voted for Brexit and the polls tightened in the US presidential election race. So far, markets have shrugged off the political uncertainty and been encouraged by continued extremely accommodative monetary policies.

After rising at a 2.5% annualized pace in 1Q, Canada's economy contracted at a 1.6% pace in 2Q, in part due to the disruption caused by the Fort McMurray wildfires. The expected 3Q16 rebound in growth is encouraging but in reality only returns the Canadian economy to subpar year-over-year growth of just over 1%. US growth averaged just 1.1% in the first half of 2016, and the Atlanta Fed's GDP Now forecast currently points to 2.4% growth for US real GDP in 3Q. On balance, 2016 growth expectations have been revised down quite sharply, for Canada to 1.2% currently from 1.9% in December and for the US to 1.5% currently from 2.4% in December.

Global growth and inflation prospects have also cooled. According to JPMorgan, global growth for 2016 is now projected at 3.1%, down from the December consensus forecast of 3.4%. Global consumer price inflation is now projected at 2.3%, down from the December consensus forecast of 2.7%. 

Meanwhile, Fed Chair Janet Yellen's message has shifted from firmly on hold ahead of the Brexit referendum to clear support for a rate hike before the end of 2016 now. At the same time, the Bank of  Canada Governor Poloz has made it clear that the BoC is content to pass the stimulus baton to Finance Minister Morneau, who will soon present a Fiscal Update that will confirm that the government is content to pursue large and growing deficits in the name of "growing the economy".

The key event in the final quarter of 2016 is, without a doubt, the US presidential election. While it can be argued that Trump's economic policy platform, if effectively implemented, would be more advantageous to Canada than Clinton's, there is no doubt that the Canadian voters who gave the Trudeau Liberals a strong parliamentary majority would prefer to see Clinton win. From a market perspective, it appears that risk markets that have so heavily depended on central bank unconventional monetary policies, would prefer a Clinton victory as more likely to see a shift toward a more expansionary fiscal policy and perhaps eventually "helicopter money". 

This leaves global markets in a potentially vulnerable position. Equity market valuations are increasingly stretched. Government bond market valuations also remained stretched as global 10-year bond yields continue to test new lows.

The declines in global bond yields are a reflection of growth disappointments and falling inflation expectations around the world and the market's assessment that this will result in continued experimentation with unconventional monetary policies. We are living in an upside down world in which weak growth and disinflation seem to lift financial asset prices because investors expect that such outcomes will spur even more accommodative monetary policy.

In a continuing uncertain environment, characterized by sluggish global growth, record high debt levels, unprecedented central bank stimulus, and a high level of political risk, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.