Thursday, 29 January 2015

Canadian Consensus Blows Apart

The Bank of Canada's decision on January 19, to cut the policy rate to 0.75% from 1.00%, took forecasters by surprise. The only thing that surprised me (see here) about the move was that it happened in January and not at the next meeting in March. The BoC clearly saw the magnitude of the negative shock of the plunge in the price of crude oil as justifying the surprise. Indeed, markets were already pricing in a 50% chance of a rate cut by June, so were less surprised than economic forecasters.

None of the economics groups at Canada's Big 5 banks expected a rate cut in 2015. Indeed, four out of five expected the policy rate to rise, beginning some time in the second half of the year (Scotia Bank was the exception). The rate hike forecasts were predicated on forecasts of modestly above trend real GDP growth, a gradually shrinking output gap, and inflation moving up to the 2% target by the end of 2016.  

Although the price of crude oil had fallen by about half by mid-January, no major changes had been made to private sector growth forecasts for 2015, and the inflation outlook treated the oil price drop as a temporary phenomenon that could be "looked through".

This consensus view of December was blown apart by the BoC's action and the accompanying Monetary Policy Report. Forecast revisions have begun and, for some of the banks, are still a work in progress. Looking at their websites, it is possible to get an idea of the magnitude and direction of the revisions.

TD Economics was the first off the mark with a complete re-forecast. It lowered the assumed 2015 average price for crude oil to $47/bbl from $68/bbl in its' December forecast. The 2015 real GDP growth forecast was cut from 2.3% to 2.0%. The CPI inflation forecast for 2015 was cut to 0.4% from 1.5% in the December forecast.

The chart below shows the evolution of CPI inflation forecasts since the Bank of Canada's October Monetary Policy Report.

Forecasters still view the decline in the price of crude oil as causing a temporary drop in the inflation rate.  The forecast for inflation at the end of 2016 is the same or possibly higher than it was in December. Of course, the forecast level of the CPI is lower, but the rate of inflation at the end of 2016 has barely budged. This outcome is to be expected in the Bank of Canada's projections because the Bank's mandate is to return inflation to the 2% target over 6 to 8 quarters. Private sector economists don't have to mimic the BoC forecast, but they pretty much always do.

So how has this weaker growth and lower inflation outlook altered forecasts for the Bank of Canada's policy rate? The following charts compare the minimum, median, and maximum policy rate forecasts made in December with the most current forecasts.

In December, all forecasters saw the BoC policy on hold at 1.00% through mid-year 2015 and then
moving up, with 4Q16 forecasts ranging from 1.75% to 2.75%. 

By the end of January, the forecasts are all over the map. One bank, RBC, sees the cut to 0.75% as being a one and done move, with the BoC reversing course by the end of June and still moving the policy rate up
to 2.75% by 4Q16. The median forecast expects another rate cut to 0.50% in March, before the BoC goes on hold for the rest of 2015 and then raises to policy rate to 1.50% by the end of 2016. One bank, TD, expects the BoC to hold the policy rate at 0.50% through 3Q16, and then to raise it to 1.00% in 4Q16.
The actual outcome will depend on how low oil prices move and how long they stay low. It is not inconceivable, if oil prices fall to $40/bbl or lower and stay down, that the BoC might lower the policy rate to its 2009 low of 0.25%. 

Some economists have suggested that the cut to 0.75% and possible further cuts risk stoking a housing bubble and eventually a crash when rates eventually rise. This seems unlikely. House prices in the oil producing regions are already falling as oil incomes plummet. In oil consuming regions, a sharply lower Canadian dollar is making imports more expensive, offsetting much of the windfall from lower gasoline prices. The banks have been slow to lower mortgage rates, so the risk of fuelling a housing bubble seems limited.


Tuesday, 13 January 2015

The BoC Should Open the Door to a Rate Cut Now

My old friend, David Wolf, recently of Fidelity Investments, but previously an Advisor at the Bank of Canada, attracted headlines last week in response to an investment commentary which he provocatively titled "Canada's Oil Slick" (see here). 

Wolf argues that, for many years, Canada has enjoyed a virtuous cycle: rising commodity prices fuelled a strong Canadian dollar, which boosted confidence, purchasing power, borrowing, consumer spending, housing prices and other asset prices. Now that virtuous cycle has turned vicious; all of these forces are working in the other direction. 

Some economists argue that the negative effects of lower oil prices will be more than offset as US and Canadian consumers get a boost from cheaper gasoline prices and Canadian exporters benefit from a lower Canadian dollar.

But Wolf contends that most economists and markets are underestimating the second and third round effects: the vicious cycle of falling commodity prices, a weakening Canadian dollar, falling confidence, slowing borrowing, falling asset prices and weakening spending that will follow the crash in oil and other commodity prices. 

As the economy and asset prices weaken, Wolf argues, "the probability that the Bank [of Canada] does eventually have to put interest rates back at zero has increased substantially". He suggests that, "The Bank of Canada does have a bit of room left to stimulate, although it will likely be hesitant to use it in the near term, partly to avoid the risk of exacerbating the household imbalances that have grown much larger since the crisis."

I believe that, in this debate, David Wolf's view is more likely to prove accurate. While I am in broad agreement with his assessment, in my opinion, he fails to mention one important link in the virtuous cycle that has turned vicious. When the price of oil [and other commodities] falls, Canada's terms of trade (ToT) weakens. When the price of commodities falls relative to the price of other goods and services, the price of Canada's exports falls relative to the price of its imports. 

When the commodity terms of trade weaken, Canada's gross domestic income weakens. This negative shock to income is shared across the corporate sector, the government sector and the household sector. While some energy consuming industries will benefit, total corporate profits will fall. Government revenues will fall, causing most governments to curtail discretionary spending. While commuters will benefit from lower gasoline prices, the lower Canadian dollar will make imports of finished consumer goods and services more expensive. As housing and other asset prices weaken against a backdrop of record high household debt-to-income ratios, consumers will be reluctant to spend any windfall bestowed by lower energy prices. Many will prefer to save rather than spend the temporary boost to disposable income.

What is noteworthy about the chart above is that the depreciation of the Canadian dollar, significant as it has been, has not kept pace with the deterioration of the commodity terms of trade. Even if oil and other commodity prices stabilize at current levels, the Canadian dollar needs to fall further, to below 80 US cents (or alternatively USDCAD needs to rise above 1.25), to have a chance to offset the negative impact of the terms of trade deterioration on growth and inflation.   

The Bank of Canada will make a policy rate decision and release an updated projection for the Canadian economy on January 21. The biggest change will be in the inflation projection. The table below shows the Bank of Canada's Total CPI inflation projection made in its October Monetary Policy Report (MPR) and JP Morgan's latest Canadian inflation forecast which incorporates most of the recent decline in crude oil prices.

The JP Morgan forecast anticipates that CPI inflation will turn negative in 2Q15 (as I predicted here) before edging back toward 1% by 4Q15 assuming that the price of oil rebounds toward $90 per barrel by the end of 2015.   If, as I believe likely, crude oil prices remain depressed for a much longer period of time, say well into 2016 or 2017, inflation will likely fall into negative territory in early 2015 and remain there for some time.

With such an outlook, the Bank of Canada needs to pay full attention to defending its inflation target and supporting inflation expectations around 2%. The most effective way to do this in the near term is to provide guidance in the January 21 policy rate announcement and the Monetary Policy Report that the BoC stands ready to cut the policy rate if inflation moves persistently below the 1-3% target band.  

Thursday, 8 January 2015

The Global Inflation Outlook for 2015

As far as the near-term outlook for asset prices is concerned, I believe that the path of global inflation is more important than the prospects for global growth. I reviewed the consensus forecast on global growth in a recent post, so now I turn to the inflation outlook. Last year, I presented the consensus outlook for inflation and, motivated by an insightful piece by Russell Napier which argued the case for strong global deflationary pressures, I also laid out an Inflation Scenario and a Deflation Scenario. By the end of 2014, Napier's prediction of a deflationary scenario was clearly playing out.

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

  • 2015 global inflation is likely to be the lowest on record;
  • Inflation is lower in DM, but is falling faster in EM;
  • Inflation drivers are much weaker in EM than in DM.

2015 Global Inflation Lowest on Record

Global inflation has consistently fallen short of expectations since 2013. 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 for the entire set of world economies was expected by the IMF to edge up from 3.7% at the end of 2013 to 3.8% by the end of 2014. By October 2014, the IMF had lifted its year-end 2015 forecast to 3.9%. Meanwhile, a year ago, JP Morgan economists expected their measure of global inflation (for 39 major economies) to edge up to 2.9% in 4Q14 from 2.8% in 4Q13. JPM economists now expect that global inflation fell to 2.3% in 4Q14. JPM's 2015 global inflation forecast is now 2.4%, which appears to be the lowest forecast on record. 

But these forecasts, made between early October and mid-December, were already DOA*. While crude oil prices had already dropped sharply to around $65 per barrel in mid-December from around $95 per barrel in early September, economists were just beginning to factor in the impact that lower fuel prices would have on inflation. Since then, the price of crude has dipped below $50/bbl and looks likely to remain depressed for a considerable period of time.

* dead on arrival

In most countries, inflation can be expected to be weaker than the consensus forecasts. While US growth has picked up, growth in the Eurozone, Japan and most emerging markets has been disappointing and still shows signs of slowing. Considerable slack remains in the global economy. Wages are not accelerating. Commodity prices, led by crude oil, are plunging. Inflation expectations are falling. Deflationary forces are becoming entrenched despite central bank efforts.

DM inflation is lower, but EM inflation is falling faster

Inflation in Developed Market (DM) economies fell to just 1.2% in 2013 and remained unchanged in 2014, undershooting forecasts made a year ago by JPM (1.7%) and the IMF (1.9%). In 2015, JPM now expects DM inflation to edge down to 1.1%. The IMF estimate, reflecting a slightly broader definition of which economies qualify as DM, is for inflation to rise from 1.7% in 2014 to 1.9% in 2015.

Inflation in Emerging Market (EM) economies fell to 3.6% in 4Q14, according to JPM’s estimate, undershooting its forecast made a year ago of 4.2%. In 2015, JPM expects EM inflation to rise to 3.8%, while the IMF estimate (for a broader group of countries) is for a decline from 5.7% at year-end 2014 to 5.4% at the end of 2015.

Inflation drivers are stronger in DM economies than in EM

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 in the major economies. They combine the effects of an estimate of economic slack; monetary conditions (the combined effect of the real central bank policy rate and movements in the foreign exchange rate); and changes in inflation expectations.

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 than the direction of the impact of each of the drivers for the individual countries.

Given the preceding caveat, the chart suggests that the largest downward push on inflation in the DM economies is occurring in the United States. The US economy is expected to grow above trend but still has a large output gap, so economic slack remains a deflationary force. Monetary conditions are tightening as the real policy rate rises and the US dollar has appreciated against most world currencies. Inflation expectations are stable based on the the consensus inflation forecast but are declining based on breakeven inflation rates between nominal US Treasuries and TIPs. 

In the UK, where the Bank of England backed away from its intentions to raise the policy rate in 2014, economic slack and monetary conditions both point to slight upward pressure on inflation but expectations point solidly in the other direction. 

In the Eurozone, where inflation has already turned negative, economic slack still weighs on inflation and inflation expectations are stuck around zero. Monetary conditions, with a zero real policy rate and depreciating currency, are supportive but not strong enough to move inflation higher.

In Japan, weak growth, economic slack and weak inflation expectations continue to weigh on inflation while highly stimulative monetary conditions, mainly achieved by the weakening of the Yen, struggle to turn the tide. 

In Canada, neither economic slack nor monetary conditions are providing much impetus to inflation. On the monetary front, Canada has one of the highest real policy rates among DM countries but has experienced a sharp currency depreciation as the terms of trade have weakened. Inflation expectations were rising gradually prior to the recent plunge in crude oil prices, but this is likely to change as inflation forecasts are marked down over the next month or so to reflect lower energy prices. Similarly, Australia appears subject to moderate deflationary impulses.

Among the EM economies, deflation pressures seem strong in China, India, Brazil and Mexico. Growth is running below trend in all of these economies and slack is developing. Monetary conditions are disinflationary in all four economies. Inflation expectations appear to be falling in China, India and Mexico. The exceptions in the EM economies are Korea, where the economy has been operating above trend, and Russia, where currency depreciation has fuelled strong inflation expectations. 


Global inflation appears likely to fall to a new record low in 2015. The plunge in the price of crude oil has not yet been fully factored in to 2015 inflation forecasts. In DM economies, where inflation was already low at 1.2% at the end of 2014, a sharp decline is expected in early 2015 as lower transportation and heating fuel prices feed through into consumer prices. The Eurozone's annual inflation rate dipped into negative territory in December. Japan's inflation rate could turn negative again once the effect of the 2014 consumption tax hike falls out of the calculation. Headline inflation rates are likely to fall below central bank target ranges in the UK, Canada and Australia in 1Q14. In EM economies, inflation drivers point to further downward pressure on inflation in the major economies with the exception of Russia, where currency weakness is driving up already high inflation. 

In this strongly deflationary environment, the consensus forecast anticipates that central banks in the US, UK, Canada, Australia, Brazil and Mexico will all raise their policy rates by 25 to 75 basis points. Barring a quick and sharp reversal in crude oil prices, such rate hikes could prove a serious policy mistake.

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. 

Friday, 2 January 2015

Global ETF Portfolios: 2014 Returns for Canadian Investors

Global ETF portfolios performed well for Canadian investors in 2014. Much of the strong performance was attributable to an 8.4% depreciation of the Canadian dollar relative to the USD that provided a tailwind and proved quite profitable for Canadian investors in global ETFs.

Global economic developments were very mixed with lots of big misses by forecasters

  • Global growth was a bit weaker than expected in 2014 and global inflation was significantly weaker than expected.   
  • Global growth divergences increased as US, UK, China, India, Canada, Australia and Korea grew at or above expectations, while Japan, Eurozone, Brazil, Russia and Mexico grew much slower than expected. Most Emerging Market economies grew well below trend with India and Korea being notable exceptions.  
  • Global inflation fell to its lowest in at least a decade, compared with forecasts at the beginning of 2014 of a meaningful rise in global inflation. The Eurozone, China, UK and Korea all posted much lower than expected inflation. 
  • Global central bank policies diverged, with the US Fed ending its QE program and preparing markets for an increase in the policy rate in 2015, while the BoJ, ECB, and PBoC eased policy. Russia and Brazil were forced to hike policy rates to support their currencies. 
  • The USD appreciated against virtually all global currencies.
  • Led by crude oil, commodity prices plunged, particularly in the September to December period, putting significant pressure on the currencies of commodity exporting countries, including Canada.
  • Bond yields fell virtually everywhere, with Russia being a notable exception.

From my perspective, a key development for markets came at the end of August, when Fed Chair Janet Yellen delivered a speech at the Jackson Hole meeting of central bankers that presented a balanced view on the outlook for the economy and the need for normalization of US monetary policy. The market had been expecting Yellen to continue with the dovish talk that had been her trademark. In a September post, I referred to the market reaction to Yellen's speech as the beginning of "Exit Ennui" as the Fed prepared markets not only for an end of QE, but for a normalization of the policy rate in 2015. As I will show in this post, global ETF performance in the final four months of 2014, as Exit Ennui took hold, was far weaker than prior to Yellen's Jackson Hole speech. With other central banks showing little or no interest in normalizing monetary policy, the appreciation of the USD accelerated. With the major economies outside the US locked into subpar growth, the rising USD created an environment in which crude oil prices collapsed and most other commodity prices continued to weaken. 

For its part, the Bank of Canada continued to signal that it was in no hurry to raise its policy rate (see my November post). After all, Canada had begun to normalize its policy rate back in 2010, raising it to 1.00% from its low of 0.25%, and already had a tighter monetary policy than other major DM economies. In this environment the Canadian dollar (CAD) depreciation versus the USD accelerated following Yellen's speech. 

Global Market ETFs: Performance for 2014

In 2014, with the USD appreciating 9.3% against the CAD, the best global ETF returns for Canadian investors were in USD denominated bond and equity ETFs. The worst returns were in commodities, Eurozone and Japanese equities and local currency Emerging Market bonds. The chart below shows 2014 returns, including reinvested dividends, for the ETFs tracked in this blog, in both USD terms and CAD terms.

Global ETF returns varied dramatically across the different asset classes in 2014. In USD terms, 10 of the 19 ETFs we track posted positive returns, while 9 ETFs posted losses for the year. In CAD terms, 17 of 19 ETFs posted gains, while just 2 posted losses. 

The best gains were in the US long bond ETF (TLH) which returned a stunning 24.8% in CAD. The S&P500 ETF (SPY) was second best, returning 24.0% in CAD. Other gainers included US Investment Grade Bonds (LQD), which returned 18.2% in CAD; USD-denominated Emerging Market bonds (EMB) 15.8%; Canadian Long Bonds (XLB) 15.4%; Canadian real return bonds (XRB) 14.6%; US small cap stocks (IWM) 14.5%; US inflation-linked bonds (TIP) 12.8%; Canadian equities (XIU) 11.9%; and US high yield bonds (HYG) 11.3%.

The worst performer, by far, was the commodity ETF (GSG), which returned -33.0% in USD and -26.8% in CAD. Eurozone equities (FEZ), returned -7.0% in USD and -1.4% in CAD. Seven other ETFs posted losses in USD terms, but showed gains in CAD terms, including non-US inflation-linked bonds (WIP) +9.1% CAD, non-US sovereign bonds (BWX) +6.9% CAD; the gold ETF (GLD) +6.9% CAD; Canadian corporate bonds (XCB) +6.5% CAD; Emerging Market equities (EEM) +5.0% CAD; Emerging Market Local Currency Bonds (EMLC) +3.3% CAD; and Japanese equities (EWJ), which gained 2.5% in CAD terms.  

Global ETF Portfolio Performance for 2014

In 2014, the Canadian ETF portfolios tracked in this blog posted strong returns in CAD terms when USD currency exposure was left unhedged, but only moderate returns when USD exposure was hedged. In a November post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.

The traditional Canadian 60% Equity/40% Bond ETF Portfolio gained 11.7% in CAD when USD exposure was left unhedged, but just 7.0% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 12.3% if unhedged, but 7.6% if USD hedged.

Risk balanced portfolios outperformed in 2014 after a relatively poor year in 2013. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a robust 19.9% in CAD terms if USD-unhedged, but had a less stellar gain of 10.2% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, ILBs and commodities but more exposure to corporate credit, returned 13.4% if USD-unhedged, but just 6.2% if USD-hedged.

Returns Weakened as "Exit Ennui" Took Hold

As mentioned, asset markets lost significant momentum in the last four months of 2014 after Janet Yellen spoke at Jackson Hole. The chart below shows global ETF returns, in local currency terms, dividing the year into the first eight months and the final four months.

In the January-August period, virtually all ETFs posted positive returns with the exception of modest losses in commodities (GSG) and Japanese equities (EWJ). In the September-December period, 13 out of the 19 ETFs posted negative returns in their local currency. Bucking that negative trend were US equities and US and Canadian long bonds. Commodities, Gold, Emerging Market ETFs, non-US equities, Inflation-Linked Bonds and High Yield bonds all posted negative returns as Exit Ennui took hold. 

As a consequence, ETF portfolio returns, while still positive thanks to a 6.9% appreciation USD versus CAD, lost significant momentum over the September-December period. In USD terms, all of the portfolios posted losses in the final four months of 2014.

This can also be seen in the tracking of weekly portfolio returns since the beginning of 2012. Two significant portfolio drawdowns have occurred over this period: the Taper Tantrum drawdown of 2013, when Fed Chair Bernanke indicated that the Fed would taper the QE program, and Exit Ennui drawdown, when Fed Chair Yellen indicated that the Fed would begin to normalize the policy rate.

While the equity-heavy 60/40 portfolio performed best over the past three years, the more conservative 45/25/30 portfolio was the second best performer as it suffered less in the drawdowns and was generally less volatile. 

As we enter 2015 in a continuing uncertain environment, characterized by US economic strength, significant global divergences in growth and central bank policies, and collapsing oil and other commodity prices, remaining well diversified with an ample cash position continues to be a prudent strategy.