Wednesday, 18 December 2013

The Outlook for Global Inflation in 2014

There are three things to know about the outlook for global inflation:

· The 2014 inflation forecast is one of the lowest on record;
· Inflation is lower in DM, but is falling faster in EM;
· Inflation drivers are much stronger in DM than in EM.

2014 Inflation Forecast lowest on Record

The year-end forecasting flurry tends to focus more on the outlook for growth than the outlook for inflation. As noted in previous posts, growth has consistently tended to fall short of consensus forecasts for the past few years, a phenomenon referred to as “the optimism bias”. What is less remarked upon is that global inflation has also fallen short of expectations. This has occurred in spite of unprecedented efforts by central banks – in the form of negative real interest rates and massive Quantitative Easing – to fight disinflation.

Last year, global inflation was expected by the IMF to ease from 4.0% at the end of 2012 to 3.7% in 2013 and 3.5% in 2014. This year, the IMF has lifted its year-end 2014 forecast to 3.8%. Meanwhile, a year ago, JP Morgan economists expected global inflation to fall to 3.2% in 2013; it is now estimated to have dropped to just 2.8%.  JPM's 2014 global inflation forecast is now 2.9%, which appears to be the lowest on record.

It seems a little odd that, despite maintaining their perennial growth optimism, economists continue to downgrade their inflation forecasts. Unemployment rates have fallen in DM economies despite tepid growth, suggesting that estimates of potential (or trend) growth have been too high and that these economies are closer to full capacity than perceived. Yet in many countries, inflation is expected to remain low or to continue to fall.

With the global economy building some momentum going into 2014, and with the lagged effects of massive monetary policy accommodation still in the pipeline, it seems very possible that inflation could be higher in 2014 than the record low forecast.

DM inflation is lower, but EM inflation is falling faster

Inflation in Developed Market (DM) economies hit rock bottom in 2013, coming in at just 1.2%, according to JP Morgan’s latest estimate, undershooting forecasts made a year ago by JPM (1.4%) and the IMF (1.7%). In 2014, JPM expects DM inflation to edge up to 1.6%. The IMF estimate, reflecting a slightly broader definition of which economies qualify as DM, is for inflation to rise from 1.7% in 2013 to 1.9% in 2014.

Inflation in Emerging Market (EM) economies fell to 4.3% according to JPM’s estimate, undershooting its forecast made a year ago 0f 4.9%. In 2014, JPM expects EM inflation to continue to fall to 4.2%, while the IMF estimate (for a broader group of countries) is for a decline from 6.0% in 2013 to 5.5% in 2014.

It seems strange that DM economies are widely perceived to have a large amount of spare capacity (i.e., large negative output gaps) and EM economies are perceived be operating above full capacity (i.e. positive output gaps), but inflation is expected to rise in DM economies and to fall in EM economies. The prevailing forecasts seem to run counter to the widely accepted aggregate supply versus aggregate demand framework employed by most central banks and private sector economists. 

Inflation drivers are stronger in DM economies than in EM

In reality, the balance between aggregate supply and aggregate demand is only one driver of inflation and often is not the most influential factor. The concept of an economy’s domestic capacity (or output gap) is of declining importance in world of globalized supply chains.

The chart below shows my rough estimates of several inflation drivers or impulses in the major economies. They combine the effects of current and prospective growth relative to trend, recent short term inflation momentum, the degree of stimulus supplied by the real central bank (CB) rate, and the effect of recent and prospective movements in the foreign exchange (FX) rate.

Before going further, I would caution that I have normalized and weighted the contributions from the various drivers in a consistent but subjective fashion that accords with my judgment. The scale of the chart has less meaning that the direction of the impact of each of the drivers for the individual countries.

Given the preceding caveat, the chart suggests to me that the largest upward push on inflation in the DM economies is occurring in Japan. With “Abenomics” in full swing and having as one of its targets raising the inflation rate to 2%, this should not be surprising. While short-term inflation momentum is still weak, growth is running above trend, monetary policy is enormously stimulative, and exchange rate depreciation has been substantial and is expected to continue.

The UK economy also has relatively strong inflation impulses, with above-trend growth and the negative real CB policy rate making notable contributions. In the US, exchange rate appreciation is containing inflation, but other drivers are positive.

In contrast, Canada has relatively weak inflation drivers, with growth around trend, low inflation momentum, a higher real CB rate than other DM economies, and only a modest push from FX depreciation. 

Among the EM economies, inflation impulses seem strongest in India and Brazil. Growth is running well below trend in both economies, but short-term inflation momentum is strong, and past and prospective currency depreciation is adding further upward pressure. In Brazil, monetary tightening has pushed the real CB rate up to the highest among the countries in the chart but, so far, with little effect.

Inflation drivers are much weaker in China, where below trend growth, a positive real central bank policy rate and steady, moderate currency appreciation are all acting to contain inflation.

Conclusions and Investment Implications

Barring a recession or another financial shock, it won’t be hard for global inflation to surpass the currently prevailing record low expectations for 2014.  Upside surprises to growth and inflation in early 2014 could pose a significant risk to financial markets by the spring. Positive growth surprises could encourage the Fed to taper its QE purchases more quickly than currently anticipated. Higher than expected inflation would add a further negative for equity markets would put upward pressure on bond yields.

The 2013 environment of disappointing global growth, lower- than-expected inflation and increasing monetary ease was an environment in which global equities and high yield debt outperformed other asset classes. Doesn’t it stand to reason that a 2014 environment of stronger-than-expected global growth and inflation and less monetary ease would likely reverse some of this outperformance?

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. 

Wednesday, 11 December 2013

The Outlook for Global Growth in 2014

There are four things to know about the outlook for global growth:

·   2014 growth “Ain’t what it used to be”;
·   2014 growth is currently expected to be better than 2013;
·   DM economies are expected to grow above trend, while most EM economies are expected to grow below trend;
·   Leading indicators support most growth forecasts.

“2014 Ain’t What It Used To Be”

There is always a year-end flurry among economists to focus on the year ahead growth forecast. For the last few years, this has resulted in expressions of disappointment that the year just finished didn’t live up to expectations combined with upbeat forecasts that “next year will be better!” The same is true this year.

Last year, global growth was expected by the IMF to pick up to 3.5% in 2013 from 3.2% in 2012. Instead, global growth is now estimated to have slowed to 2.8% in 2013.
This year, forecasters tell us once again that global growth will pick up from a disappointing 2.8% in 2013 to 3.6% (IMF October forecast) or 3.3% (JPMorgan December forecast). This forecast for 2014 is presented as upbeat news, but the reality is that the 2014 forecast for has already faded from the 4.1% forecast published by the IMF in January 2013.

2014 growth to be stronger, almost everywhere

In most countries, growth is expected to pick up in 2014. Economies with the largest forecast pickup in growth include Mexico (3.4% vs 1.4%), UK (3.0% vs 1.5%), Eurozone (1.1% vs -0.4%), Korea (3.7% vs 2.8%) and US (2.5% vs 1.7%).

Modest growth improvements are expected in Canada, Australia, India and Russia. In two major countries -- China and Brazil -- growth is expected to slow in 2014.

DM above trend … EM below trend

While global growth is expected to pick up in 2014, the divergence between DM and EM growth that began in 2013 is expected to continue. In the chart below, the blue bars show the 2014 growth forecast versus the trend growth rate for each economy.

In 2013, Japan was the only major country to post growth above the OECD estimate of its trend growth rate. In 2014, the larger DM economies are expected to grow well above trend, while Canada and Australia are expected to grow around trend. In contrast, all of the major EM economies, except Mexico, are expected to grow well below trend. 

Leading indicators support most growth forecasts

In the chart above, the red bars show the latest OECD composite leading indicators (CLIs) for each of the economies. These CLIs support 2014 growth forecasts, with a few exceptions.

In the DM economies, the leading indicators suggest that growth could surprise on the upside in US, Eurozone and Japan. In Japan, however, the low forecast relative to the CLI reflects the expected effect of a significant increase in the consumption tax.

In the EM economies, CLIs suggest that growth could be stronger than expected, but still below trend in China, Russia and Brazil. On the other hand, CLIs suggest that growth forecasts for India and Mexico may be significantly too optimistic.


Will 2014 be the year that the major DM economies finally shake off deleveraging and fiscal austerity and move to above trend growth? If so, global bond yields are likely to rise as markets price in less accommodative monetary policies. Will 2014 be another year of below trend growth for the major EM economies? If so, commodity prices are likely to remain weak and capital is likely to continue to flow out of EM economies. 

The question one should ask about 2014 forecasts is this: Can still highly indebted DM economies sustain above-trend real GDP growth in an environment of rising real interest rates and below-trend EM growth? Or will we look back on 2014 as another year that started with optimistic forecasts and ended with disappointment? I suggest that investors should stay on their toes.

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. 

Tuesday, 3 December 2013

Portfolios for Canadian ETF Investors

November Review and December Outlook

In November, as Washington returned to business as usual following October’s government shutdown, stronger economic data and the appointment of Janet Yellen as the new Chair of the Federal Reserve provided a further boost to equity markets. By the end of November, however, Robert Shiller was advising caution toward equities based upon over-extended valuations, but stopped short of “sounding the alarm”. Evidence on US growth was more positive in November following a sharp decline in the Economic Surprise Index in October. The 4-week moving average of initial claims for unemployment insurance fell back to 332,000 by November 23 from 358,000 on October 26. The October US employment report posted a stronger-than-expected gain of 204,000 payroll jobs, but the unemployment rate edged up to 7.3% from 7.2%.

Middle East tensions cooled substantially as implementation of the Russia-brokered agreement by Syria to destroy its chemical weapons began and the US-led negotiations with Iran over its nuclear program yielded a tentative agreement. With easing geopolitical risk and rising supply, crude oil prices continued their steady slide. After rising to $110 in September, their highest levels in two years, WTI futures prices fell through October and November to reach $92. Gold prices, responding to renewed concerns that the Fed will proceed with tapering of Quantitative Easing, continued to weaken, closing November at $1251 down from $1323 at the end of October. Corn prices also plummeted as the US EPA reduced the ethanol requirement for gasoline. As prices fell, commodities and inflation-linked bonds continued to be the worst performing asset classes of 2013.

With crude oil and gold prices declining, the Canadian dollar remained on a weakening trend. After being supported by the Fed’s decision to delay tapering of QE in September, BoC Governor Poloz surprised markets in October by dropping the long standing tightening bias. With the tightening bias gone and commodity prices falling the C$ continued to weaken, dropping 1.7% against the US$ in November.  

Global Market ETFs Performance

The continued delay of Fed tapering, the Yellen confirmation and reduced Middle East tensions supported global equity markets. The S&P500 hit a record closing high of 1807 on November 27. Global equity ETFs posted solid returns in November in CAD terms, led by US (SPY), which returned +4.8%, Japan (EWJ) +3.1%, Eurozone (FEZ) +2.6%, and Emerging Markets (EEM) +1.5%. US small caps (IWM) returned 5.8%, outperforming the S&P500. Canada (XIU) underperformed, returning 0.8% reflecting the ongoing weakness in commodity prices. 

Bond market ETFs were mixed in November. Canadian bonds (XBB) gave back most of October’s gains, returning -0.6% in November. US long bonds (TLH) returned -1.8% in USD terms but with the weakening of the C$, lost only 0.1% return in CAD terms. Non-US global government bonds (BWX) posted a return of 0.4% in CAD terms. Emerging Market bonds performed poorly as USD-denominated bonds (EMB) returned -0.3% and EM local currency bonds (EMLC) returned -1.6% in CAD terms.

 Inflation-linked bonds (ILBs) were mixed. While Canadian RRBs (XRB) -- the worst performer -- returned -2.4%, non-US ILBs (WIP) returned -0.1%, and US TIPs (TIP) gained 0.7% in CAD terms.

US investment grade (LQD) and high yield (HYG) bonds posted solid gains in CAD terms, returning 1.6% and 2.2%, respectively. Canadian corporate bonds (XCB) underperformed, returning -0.1%.

For November, a traditional Canadian 60% Equity ETF/40% Bond ETF Portfolio gained 155bps bringing its YTD return up to 14.8%. A Levered Risk Balanced (RB) Portfolio gained 35bps in November, bringing its YTD return up to about 2.1%, after it suffered a severe 8.1% drawdown over the April 26 to June 21 period. An Unlevered Risk Balanced (RB) Portfolio returned 159bps in November, raising its YTD return to 8.7%. The weaker returns in the Levered RB portfolio were attributable to the sell-off in the leveraged positions of Canadian nominal and I-L bonds.

Expectations for December

December brings a new set of issues for markets as the year draws to a close. Key developments that markets will be watching:

·   US fiscal issues have been kicked down the road with the continuing resolution and Debt Ceiling deadlines temporarily extended into early 2014. There is an interim deadline for a bipartisan plan to replace sequestration with more palatable spending cuts by December 13, but there are no serious consequences if the deadline is not met. That means that uncertainty and market volatility over fiscal issues will not be a major factor until late in 1Q14.
·   Over the past month, economic growth data have been stronger than expected. The US Economic Surprise Index rose from -3.8 on November 4 to +9 on December 2. The JPMorgan Global Manufacturing PMI edged up to 53.2 in November from 52.1 in October, boosted by a solid gain in US Manufacturing PMI.
·   Globally, inflation continues to fall to the lowest readings since the Financial Crisis. Headline inflation has fallen below 1% in Canada and the Eurozone and remains sluggish in Japan. Central banks with inflation targets are being pressured to defend them with policy rate cuts or other forms of easing.
·   Central banks, which have focused heavily on supporting stronger recoveries and reducing output gaps are seeing some positive signs on this front. However, inflation continues to surprise on the down side and central banks are mandated to keep prices from slipping towards deflation. While stronger growth may lead some to believe that the Fed and other central banks will begin reducing monetary stimulus sooner, falling inflation is likely to keep central banks from doing so.    

In this environment, commodity prices continue to slide.  Global excess supply conditions continue to weigh on oil prices and the spectre of Fed tapering is kryptonite to gold. Inflation pressures remain very weak and the risk of inflation dropping below 0% in many DM economies is real.

From a market perspective, political risks have temporarily subsided, while growth surprises have turned modestly more positive and inflation disappointments continue. This is still an unfavorable environment for commodity prices and commodity currencies. It is also a weak backdrop for corporate earnings growth.

Last month, I concluded that, “with cash returns pegged close to zero, the Fed extending QE indefinitely, and investors concerned that a bond market sell-off could resume with a vengeance if positive growth surprises re-emerge, it seems that flows into equities and corporate bonds will continue and could sustain further gains in these asset classes through November”. That proved correct. However, the continued run-up in equity prices has several high profile valuation gurus, including Robert Shiller and Jeremy Grantham warning that US equity valuations are rich. Yet both are stopping short of “sounding the alarm”, acknowledging that equities could rise another 20-30% over the next two years if monetary stimulus continues unabated.

Signs of extreme equity market froth do not seem present. If US economic data remain buoyant and inflation remains extremely muted, the Fed will likely find reasons to continue to postpone tapering and, in the process, continue to support equity prices. The market is clearly vulnerable to a 10+% correction over the next few months, but this seems more likely to be a 2014 story than a December 2013 event.

Equities, credit and government bonds are all richly valued but continue to be supported by near-zero interest rates and massive central bank liquidity injections. As equity prices continue to rise, the risk of a sharp correction when the Fed begins to taper continues to loom. When such a correction develops, it will likely be triggered by a sharp sell-off in government bond markets, which then spreads into the credit and equity markets. 

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.