Monday, 1 September 2014

Global ETF Portfolios for Canadian Investors: August Review and Outlook

Global markets provided solid returns in August as geopolitical risk seemed to ebb through mid-August, and Mario Draghi stole the show at the central bankers’ confab at Jackson Hole by hinting at further ECB monetary stimulus. For Canadian investors with currency-unhedged portfolios of global ETFs, it was another highly profitable month. Significant market and global macro developments in August included:

  • Global equity ETFs were mostly higher. US, Emerging Market, and Canadian equity ETFs posted solid gains, while Eurozone equities were flat and Japanese stocks were down. 
  • US and Canadian government bond ETFs posted strong gains, while European and Emerging Market Local Currency bonds performed relatively poorly as their currencies weakened.
  • The US dollar strengthened against most major currencies. 
  • Gold stabilized but the commodity ETF posted a second consecutive sharp monthly loss. 
  • Energy prices weakened as the WTI crude oil futures price fell to $96/bbl at the end of August.
  • US and Canadian GDP growth posted better than expected 2Q rebounds but Europe and Japan reported much weaker than expected 2Q growth.    
  • Global inflation moderated in July after picking up in May-June, with Eurozone inflation falling to just 0.3%. 
  • The Jackson Hole meeting of central bankers underscored the divergent paths of central banks, with the US Fed and BoE preparing rein in monetary stimulus while the ECB and BoJ are under pressure to increase stimulus. The Bank of Canada prefers to remain neutral as to whether its next policy move will be a tightening or an easing. 

Global Market ETFs: Monthly Performance for August

The S&P500 closed August at a record-high 2003, up from 1931 at the end of July and 1960 at the end of June. Global equity ETFs were mostly higher in August. Despite a sharp weakening in early August after an erroneous employment report, the C$ closed August with a gain of 0.2% vs. USD, slightly moderating Canadian dollar returns on USD denominated ETFs. US Small Cap stocks (IWM) were the top performers among the equity ETFs we track, gaining 6.7% in CAD terms. US Large Cap stocks (SPY) returned 3.7%, Emerging Market equities (EEM) returned 2.6%, and Canadian equities returned 1.6%. Eurozone equities (FEZ) were flat in August in CAD terms. The worst performers were Japanese equities (EWJ), which returned -1.9% in CAD terms.

Commodity ETFs were mixed. The Gold ETF (GLD) returned 0.3% in CAD terms, while the GSCI commodity ETF (GSG) returned -1.8%.

Global bond ETFs posted mixed returns. ETFs with positive returns in August included the US long government bond (TLH), which returned 2.4%, Canadian Long Government bonds (XLB), which posted a 2.3% return, and USD-denominated Emerging Market bonds (EMB) and EM Local Currency Bonds (EMLC), which returned 1.0% and 0.1% in CAD terms, respectively. Non-US government bonds (BWX) were flat in CAD terms, as weakness in the Euro and widening spreads on some Eurozone periphery bonds offset gains in Germany in other markets.

Inflation-linked bonds (ILBs) posted more modest positive returns in August as global inflation moderated. Canadian RRBs (XRB) returned 0.7%, while US TIPs (TIP) returned 0.4% in CAD terms. Non-US ILBs (WIP) returned 0.7%.

Corporate bonds performed well in August as US investment grade (LQD) and high yield (HYG) bonds returned 1.8% and 2.1% respectively, in CAD terms. Canadian corporate bonds (XCB) returned 0.8%.

Year-to-date Performance through August

In the first eight months of 2014, with the Canadian dollar depreciating 2.4% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in Canadian equities (XIU), Canadian inflation linked bonds (XRB), and US long term bonds (TLH). The worst returns were in Japanese equities (EWJ) and commodities (GSG). It seems unusual, and perhaps unsustainable, that Canadian equities are world-beaters in a year in which commodity ETFs have been among the worst performers.

In global equities, the Canadian equity ETF (XIU) performed best, returning 16.6% year-to-date (ytd). The S&P500 ETF (SPY), which hit a record high, returned 7.7% in CAD terms. Emerging Market equities (EEM), after a rough start to the year, rebounded to return 11.1% ytd in CAD terms. The Eurozone equity ETF (FEZ), which had been the top performer through May, suffered from geopolitical tensions and currency weakness in June through August and returned 1.3% ytd in CAD terms. The Japanese equity ETF (EWJ), after losses in August, returned just 0.1% ytd in CAD terms. US small caps (IWM), after rebounding in August, returned 7.5% ytd in CAD terms.

Commodity ETFs had lackluster performances this summer after strong starts to the year, dragging down year-to-date returns. The Gold ETF (GLD) has returned 9.2% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned just 0.1%.  

Global Bond ETFs continued to perform extremely well for Canadian investors. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, safe haven demand, and accommodative central bank policies. The US long bond ETF (TLH) returned 13.3% ytd in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of +11.6% ytd. USD-denominated Emerging Market bonds (EMB) returned 11.1% ytd in CAD terms. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 7.1% in CAD terms. Non-US global government bonds (BWX) posted a return of 7.0% ytd. 

Inflation-linked bonds (ILBs) continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has fared best, benefiting from its long duration, returning 13.5% ytd. Non-US ILBs (WIP) returned 10.5% in CAD terms, while US TIPs (TIP) returned 8.4%.

In corporate bonds, the US investment grade bond ETF (LQD) returned 10.2% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 7.2% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 5.2%.

Global ETF Portfolio Performance through August

In August, the Global ETF portfolios tracked in this blog posted strong gains, adding to positive year-to-date returns, which has been aided by the weakness of the Canadian dollar.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 154 basis points in August to be up 9.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 181 bps to be up 8.6% ytd.

Risk balanced portfolios also posted robust gains. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained 240 bps in August, boosting to its year-to-date gain to 15.4%. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit and emerging market bonds, returned 183 bps in August to be up 10.1% ytd.

Outlook for September

The Ukraine crisis, which seemed to stabilize through August as Ukrainian forces pushed back Russian supported rebels. But in the final days of the month, NATO reported that Russian tanks and troops crossed the Ukrainian border, taking hostilities to a new level and likely triggering a new round of sanctions on Russia. Conflict continued in Iraq, with the US launching air strikes against ISIS. Geopolitical risks, which appeared to be waning through much of August, really did not.

Key developments that Canadian ETF investors should be watching in September include:

  • US labor market developments will remain a key focus because that is what Fed Chair Yellen is watching. A strong August employment report on September 5, especially if it provides evidence that wages are accelerating could add to speculation that the Fed will have to raise the policy rate sooner tan currently expected.
  • US dollar strength will continue to be fueled by safe haven flows (as NATO tries to counter Russia incursions into Ukraine and the US contemplates air strikes on ISIS in Syria), and by the divergent monetary policy paths being taken by the Fed and the ECB toward tightening and the ECB and BoJ toward maintaining or increasing monetary ease.  
  • The Bank of Canada’s policy rate decision on September 3, when the BoC will react to solid 2Q real GDP growth of 3.1%, an upward revised July employment report, and inflation moving closer to the 2% target. I expect that the BoC will continue to find reasons to remain neutral on the direction of the next policy rate move. Further weakening of the Canadian dollar will be tolerated.
  • The debate between US equity bulls who favor buying every dip and those advising caution due to high equity valuations (see here) will continue. The S&P500 had its best August in 14 years, according to CNBC. Ironically, that takes us back to August 2000, the peak of the Tech Bubble.    
  • Concerns about global inflation are more balanced than earlier this year. Inflation has accelerated somewhat in the US, UK, Japan and Canada, but decelerated toward deflation in the Eurozone. The risk of a global deflationary shock still seems much greater than the risk of an inflationary shock. 

In recent monthly reviews, I have concluded that, “Having ample cash in the portfolio remains a good strategy until the unstable disequilibrium of weak growth, low inflation, accommodative central banks and stretched asset valuations is resolved.”

As it turned out, the ample cash dampened returns in my desired portfolio in July and August, but returns were still quite acceptable. The unstable equilibrium that has allowed equity  prices to drift steadily higher this year could persist for months or it could come to a volatile and sudden end. Prudence leads me to continue to favor an ample 30% cash allocation as we await the denouement.

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