Thursday, 23 October 2014

Equities Rebound: Is It Safe?

This post asks the question: "With global equities rallying back, "Is It Safe?" to take an aggressive position in risk assets. To set the mood, you might (or might not) want to watch this clip of Dustin Hoffman and Laurence Olivier in the movie Marathon Man.

In the last few posts, I have been writing about the sell-off in asset markets that began after Fed Governor Janet Yellen spoke at the Jackson Hole conference at the end of August. Yellen's speech was balanced and this spooked markets into thinking that the Fed might tighten sooner than expected. I referred to this concern as "Exit Ennui" and compared it with the selloff in asset markets that occurred in the May 2013, the so-called "Taper Tantrum". Bonds, commodities, high yield credit, EM equities and US small cap stocks all sold off over the first three weeks of September, while US and other DM stock markets held up well. However, in mid-September, signs of slower global growth, including falling crude oil prices, caused the sell-off that started with Fed tightening concerns to shift to global equity markets and a sharp correction followed. Commodities continued to sell off but bonds rallied back, with the 10-year US Treasury yield falling to 2.15%, its lowest since prior to the Taper Tantrum. 

The low point for equities was reached on October 16. On that day, equity markets turned higher when St. Louis Fed President James Bullard suggested that the Fed should consider extending QE, "to make sure inflation and inflation expectations remain near our target". The Bank of England's Chief Economist followed the next day with a suggestion that weak global growth should perhaps keep the Bank of England from raising its policy rate for an indefinite period. Since then, equities have roared back and bonds have given back some of their gains. 

The chart below, using weekly closes, shows the maximum drawdowns since August 29 (in Canadian dollar terms) for the ETFs regularly tracked in this blog and their subsequent rebounds.

The largest declines were in Canadian equities (XIU), commodities (GSG), Eurozone equities (FEZ) and Emerging Market Equities (EEM). Gold (GLD), US small cap equities (IWM) and Japanese equities (EWJ) also saw large drawdowns. In fixed income ETFs, the largest drawdowns, which occurred in the first three weeks of September, were in Canadian inflation linked bonds (XRB), Canadian Long Bonds (XLB) and non-US Developed Market government bonds (BWX). Corporate bonds had the smallest drawdowns.

What about the rebound? Which assets have performed best? The strongest rebound has been in US small cap equities (IWM), followed by US long Treasury bonds (TLH). Both of these ETFs have more than recovered from their drawdowns. 

Which assets have lagged in the rebound? Commodities have continued to flounder, not yet having found a bottom, although there were tentative signs of a rebound this week. With commodities not rebounding, Candian equities (XIU) and Emerging Market equities (EEM) have lagged other equity ETF rebounds. In fixed income, US long Treasury bonds (TLH) and US investment grade corporate bonds (LQD) have led the rebound, while emerging market local currency bonds (EMLC) have lagged.

While the Exit Ennui drawdown has been the biggest correction of 2014, the "buy the dip" mentality is clearly alive and well. The portfolios we track hit their weekly lows on October 10. With Bullard's help they have rallied back, but all remain lower than their August 29 levels. 

The question now is: with equities having rallied back, "Is it Safe?" to take a more aggressive position on risk assets. The answer is probably yes, but still with great caution.

Equities are still overvalued by reliable metrics, although a bit less so than at the end of August. Q3 earnings reports are coming somewhat mixed, but do not yet show signs of any surprising weakness. 

Bonds, which were already overvalued in late August, are now more overvalued and are at risk of giving back their recent sharp price gains if US economic data remain on the strong side. 

What investors need to be wary of is a series of bond sell-offs which trigger equity sell-offs. This would be the reverse of the pattern witnessed throughout the period of increasingly accommodative monetary policy as measured by the growth of the balance sheets of the US Fed and other major central banks.

While Mr. Bullard may have turned around the equity correction for now, Dallas Fed President Richard Fisher voiced the opposing view that. Despite the equity sell-off, the Fed should not delay its exit from QE. Fisher said:
"We've been floating this market with the Ritalin of easy monetary policy… indiscriminate investing took place ... all boats rose regardless of underlying value... People will actually have to do work ... have to understand analysis in order to make good investments."
So, "Is it Safe?" If the Marathon Man doesn't know, who does? 

Thursday, 9 October 2014

Oscillate Wildly: The Drawdown So Far

Oscillate Wildly is a catchy instrumental by The Smiths that you might want to listen to in an effort to calm yourself as market volatility ratchets up. In a post back on May 16 that I dubbed Comfortably Numb (after the Pink Floyd song), I noted that volatility across all asset classes had been low and falling for months and that investors risked being lulled into complacency by huge central bank liquidity injections. 

I said in May that the period of suppressed volatility could end either:

  • when stronger than expected US and global growth caused a spike in bond volatility and bond yields, or 
  • when weaker than expected growth caused a spike in equity volatility and a sharp correction in overvalued equity markets.
I suggested that since it was difficult to determine which of these scenarios would play out, that the prudent course of action was to trim risk exposures across all asset classes and temporarily move into cash. This seemed a good choice because, as I noted, "When the inevitable rise in volatility occurs, it will be possible for the investor to analyze which scenario is playing out and, once it has run its course, where to put the cash back to work". 

The recent spike in equity volatility and sell-off in global equity markets is not a straightforward case. It began after Fed Chair Janet Yellen gave a balanced speech at Jackson Hole that noted the strengthening of US growth and progress toward reducing labor market slack. The speech spooked markets into thinking that the Fed might hike rates sooner than expected. Bond volatility rose as bonds sold off, while equities hung in relatively well through mid-September. But as September gave way to October, market concerns shifted to the weakness of global growth, especially in the Eurozone and to the continuing drop in commodity prices. As growth concerns gained the upper hand equity volatility spiked and global equity markets sold off sharply. 

In a September post entitled Exit Ennui, I compared the current selloff across asset markets with the selloff witnessed in the spring of 2013 associated with the Taper Tantrum. It's interesting to update that comparison today, after a particularly bad day for global equity markets.

The two episodes had several things in common. Both were triggered initially by concerns about a shift to less accommodative US monetary policy. Both saw declines across all asset classes, as illustrated in this chart which shows local currency returns on the ETFs tracked regularly in this blog.

The drawdown in equities in the Exit Ennui selloff through October 8 is similar or worse than in the Taper Tantrum. The S&P500 ETF (SPY) has suffered a similar loss. Other DM equity markets, including Canada (XIU), Eurozone (FEZ), Japan (EWJ) and US Small Cap (IWM) have suffered worse losses than in the Taper Tantrum. The commodity ETF (GSG) has also experienced a much sharper loss, reflecting the downside surprises on global growth.

Fixed income ETFs, which fared poorly through mid-September have rallied back as global equities sold off. US and Canadian long bond ETFs (TLH and XLB) are back to close to flat since the beginning of the selloff. Inflation linked bond ETFs have sold off much less than in the Taper Tantrum, as have Emerging Market bond ETFs (EMB and EMLC) and corporate bond ETFs (XCB, LQD and HYG).

The movements in these ETFs tells me that what started out as an early Fed tightening scare has morphed into a global growth scare. Markets are pushing back expectations of when the Fed will begin to raise rates once again.

For Canadian investors in global ETFs, the pain of the selloff has been mitigated somewhat by the coincident weakening of the Canadian dollar. In the Exit Ennui selloff, the C$ has weakened 2.8% vs. the US$, more than double the 1.3% it weakened during the Taper Tantrum. This has meant that the drawdown triggered by Exit Ennui is taking a different shape from that of the Taper Tantrum as shown in this chart of ETF returns in Canadian dollars.

The chart clearly shows that in the Exit Ennui drawdown, which began with a selloff in bond markets, the best place for Canadian investors to hide has been US dollar denominated bonds.

As a result, risk balanced portfolios have performed better than a conventional 60/40 portfolio in the Exit Ennui drawdown. 

It is still too early to draw a conclusion about the current drawdown and to redeploy cash. The main question that needs to be answered is whether the slowdown that is engulfing Europe, Japan and many of the emerging markets will spread to the US, UK and Canada. If so, US and global equities have considerably more downside. If not, and growth in these countries proves resilient, equities may stabilize, but bonds could come under renewed pressure. Those who took the prudent advice can sit tight and listen to Oscillate Wildly.   

Wednesday, 1 October 2014

Global ETF Portfolios for Canadian Investors: Review and Outlook

Global markets pulled back in September. The month divided into two parts. The first three weeks saw US bonds selling off and the S&P500 holding its ground as markets priced in the possibility that Fed tightening might begin earlier in 2015 than previously anticipated. The last seven trading days of the month, saw a different dynamic, characterized by global growth concerns. Bonds recovered some ground, but equities sold off at the end of the month. For Canadian investors with currency-unhedged portfolios of global ETFs, losses were mitigated by another sharp weakening of the Canadian dollar.  Significant market and global macro developments in September included:
  • Every ETF we track in this blog lost ground in September in local currency terms.
  • The US dollar strengthened against most major currencies, including a 3% monthly gain against the Canadian dollar. 
  • Global equity ETFs were weaker across all major markets. The bigger losses were in Emerging Markets, US small cap, and Canadian equities. 
  • Global government bond ETFs posted mixed returns, with long duration US and Canadian bond ETFs posting the best returns and Emerging Market Local Currency bonds posting the worst returns.
  • Gold and commodity ETFs posted further sharp losses. 
  • Energy prices weakened further as the WTI crude oil futures price fell to $91/bbl at the end of September.
  • US GDP growth for 2Q was revised up to 4.6%, but growth stalled in Europe and showed further signs of weakening in China.    
  • Global inflation moderated in August as energy and corn prices fell. Eurozone inflation remained stuck at 0.3%. 
  • Central banks continue to be on divergent paths, with the US Fed and BoE preparing markets for policy rate hikes within six to nine months while the ECB and BoJ remain under pressure to increase stimulus. The Bank of Canada remains neutral as to whether its next policy move will be a tightening or an easing and seems to be clearly signalling that it has no intention of tightening ahead of the Fed. 

Global Market ETFs: Monthly Performance for September

The S&P500 closed September at 1972, down from a record-high of 2003 at the end of August, but was still up modestly from 1960 at the end of June. Global equity ETFs were uniformly lower in September. For Canadian investors with unhedged foreign equity exposures, however, the weakening of CAD turned some of these losses into gains. US Large Cap stocks (SPY) lost 1.8% in USD terms, but gained 1.1% in CAD terms. Japanese equities (EWJ) lost 0.3% in USD, but gained 2.6% in CAD terms. Eurozone equities wee down 2.8% in USD but flat in CAD terms. Other equity ETF losses were too large to be offset by currency movements. Canadian equites (XIU) lost 4.0%, while US small cap stocks and Emerging Market equities (EEM) lost 1.4% and 5.0% respectively in CAD terms. 

Commodity ETFs posted further sizeable losses.  The Gold ETF (GLD) returned -3.5% in CAD terms, while the GSCI commodity ETF (GSG) returned -3.3%.

Global bond ETFs posted mixed returns in CAD terms. ETFs with positive returns in September included the US long government bond (TLH), which was down 1.3% in USD but returned 1.6% in CAD, and USD-denominated Emerging Market bonds (EMB) which returned 0.7% in CAD terms. ETFs with negative returns included Canadian Long Government bonds (XLB), which posted a -1.7% return, EM Local Currency Bonds (EMLC), which returned -1.7% and Non-US government bonds (BWX) which lost 1.5% in CAD terms.

Inflation-linked bonds (ILBs) also posted losses in September. US TIPs (TIP) lost 2.6% in USD terms, but gained 0.3% in CAD terms. Canadian RRBs (XRB) returned -2.3%, while Non-US ILBs (WIP) returned -2.7% in CAD terms.

Corporate bonds were also mixed in September. US investment grade (LQD) and high yield (HYG) bonds lost ground in USD but returned 1.2% and 0.9% respectively, in CAD terms. Canadian corporate bonds (XCB) returned -1.0%.

Year-to-date Performance through September

In the first nine months of 2014, with the Canadian dollar depreciating 4.6% against the US dollar, the best global ETF returns for Canadian investors in CAD terms were in US long-term bonds (TLH), US large cap stocks (SPY) and USD-denominated Emerging Market bonds (EMB). The worst returns were in commodities (GSG) and Eurozone equities (FEZ). Canadian equities, which were the top performers through August, finally succumbed to weak commodity prices in September.

In global equities, the S&P500 ETF (SPY), returned 13.3% year-to-date (ytd) in CAD terms. The Canadian equity ETF (XIU) returned 11.9% ytd. US small caps (IWM), returned 6.0% ytd in CAD terms. Emerging Market equities (EEM), after a rough September, returned 5.5% ytd in CAD terms. The Japanese equity ETF (EWJ), after rebounding in September, returned 2.8% ytd in CAD terms. The Eurozone equity ETF (FEZ), which had been the top performer through May, continued to suffer from geopolitical tensions and EUR weakness and returned 1.3% 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 5.4% ytd in CAD terms, while the GSCI commodity ETF (GSG) returned -3.2%.  

Global Bond ETFs lost some of their lustre in September. Foreign bond ETFs have benefited from a combination of weaker than expected global growth, weakening commodity pricessafe haven demand and accommodative central bank policies. The US long bond ETF (TLH) returned 15.1% ytd in CAD terms. USD-denominated Emerging Market bonds (EMB) returned 12.9% ytd in CAD terms. The Canada Long Bond ETF (XLB) posted a gain of 9.7% ytd. Non-US global government bonds (BWX) posted a return of 5.4% ytd. Emerging Market local currency bonds (EMLC) suffered from EM currency weakness to return 5.2% in CAD terms. 

Inflation-linked bonds (ILBs) weakened in September but continued to turn in strong year-to-date gains after a disastrous performance in 2013. The Canadian real return bond ETF (XRB) has benefitted from its long duration, returning 10.9% ytd. US TIPs (TIP) returned 8.7% in CAD terms, while Non-US ILBs (WIP) returned 7.5% in CAD terms.

In corporate bonds, the US investment grade bond ETF (LQD) returned 11.5% ytd in CAD terms, while the US high yield bond ETF (HYG) posted a return of 8.1% as high yield spreads widened. The Canadian corporate bond ETF (XCB) returned 4.1%.

Global ETF Portfolio Performance through September

In September, the Global ETF portfolios tracked in this blog posted losses, trimming their year-to-date gains, which have been boosted substantially by the weakness of the Canadian dollar.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio lost 103 basis points in September to be up 8.2% ytd. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, lost just 52 bps to be up 8.1% ytd.

Risk balanced portfolios also posted losses. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 136 bps in September, but was still up an impressive 13.9% ytd. 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 71 bps in August to be up 9.4% ytd.

Outlook for October

Key developments that Canadian ETF investors should be watching in October include:
  • US labor market developments remain a key focus. FOMC members have begun to prepare markets for increases in the Fed Funds rate in 2015. QE is ending and a "normalization" of the policy rate is expected to follow. I wrote about "Exit Ennui" in mid-September (see here). While US employment growth remains relatively strong and US real GDP growth remains solid, growth in Europe is stagnant and growth in China appears to be weakening. This is likely to create tension within the FOMC as hawks focus on US relative strength while doves give more weight to moderate inflation and weakness outside the US.
  • This divergence is pushing the USD higher against all currencies and potentially weakening S&P500 earnings for those companies with significant foreign operations. US dollar strength will continue to be fuelled by safe haven flows and by the divergent monetary policy paths being taken by the Fed and the BoE toward tightening and the ECB and BoJ toward maintaining or increasing monetary ease.  
  • The Bank of Canada will find ample reason to remain neutral on the direction of the next policy rate move. Canada's real GDP began 3Q on a softer trajectory and the terms of trade continue to weaken. 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) continues.     
  • After moderating over the summer, global disinflation concerns reemerged in September. Weaker growth in the Eurozone, Japan and China, falling crude oil and corn prices, in the dampening effect of geopolitical tensions on consumer confidence all add to global disinflationary pressures. 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 cushioned losses in my desired portfolio in September. Both bond and equity prices corrected in September, but these corrections made only a slight dent in asset overvaluation (see here). What was interesting in September was that bonds led the sell-off through the first three weeks, but equities experienced bigger losses by the end of the month. The unstable equilibrium is nowhere near corrected. Prudence continues to favor an ample cash allocation.