Tiff, We Hardly Knew Ye!

Tiff Macklem will soon be leaving his post of Senior Deputy Governor of the Bank of Canada to take on the role of Dean of the Rotman School of Management at the University of Toronto. On February 7,  Macklem gave his final Bank of Canada speech, titled "Flexible Inflation Targeting and Good and Bad Disinflation". It is perhaps the most insightful statement yet on how the Bank of Canada's views on the inflation process have evolved in the years since the Great Financial Crisis. 

With the BoC preparing for the rate decision on March 5, Macklem's clearly expressed views on why inflation has fallen below the BoC's 2% target and remained there for 20 months should be required reading for all Bank of Canada watchers.

The key insights in Macklem's speech include:

• the most important driver of Total CPI inflation in Canada is global Total CPI inflation,
• domestic factors are important in the dynamics of Core CPI inflation in Canada,
• the output gap does not play a significant role in determining core inflation,
• inflation expectations remain fairly stable around 2%, but there is a risk that expectations will decline if inflation remains persistently below 2%,
• increased domestic retail competition appears to be a factor holding inflation below the 2% target,
• disinflation caused by increased competition and/or productivity is considered "Good Disinflation" by the BoC and does not require a monetary policy response,
• disinflation caused by a shortfall of aggregate demand is considered "Bad Disinflation" by the BoC and does require a monetary policy response.

Total CPI Inflation

Macklem explains, "Looking at the relevance for Canada of global inflation developments, it is evident that Canada’s total inflation rate co-moves substantially with the common factor in inflation among advanced economies, underscoring the importance of energy and food prices for movements in total CPI inflation in Canada." Most of the variation in Canada's total CPI inflation is explained by movements in global inflation, which in turn are driven by movements in global food and energy prices.

Core Inflation and the Output Gap

Macklem goes on to point out that the conventional assumption that core inflation is significantly influenced by the output gap is not borne out the evidence. Econometric estimates of the influence on core CPI inflation of the output gap suggest a coefficient value of around 0.1 which does not meet standard tests for statistical significance. Given the BoC's assessment that the current negative output gap is about 1¼%, Macklem notes that the output gap would predict core inflation of 1.9%, well above recent levels of just over 1%. This implies that a large positive output gap of 5 to 10% of potential GDP would be required to return core inflation to the 2% target. As Macklem points out, "This is not realistic".

Inflation Expectations

Inflation expectations are fairly stable, but are under downward pressure as long as inflation continues to fall short of the 2% target. Consensus forecasts by economists expect inflation of 1.5% in 2014 and the majority of respondents to the BoC's Business Outlook Survey expect inflation between 1% and 2%. Macklem argues that there is "little evidence that inflation expectations are becoming unhinged from the 2 per cent target", but acknowledges that if disinflation persists, there is a risk that inflation expectations will also decline. 

Retail Competition

The entry to Canada of many big-box retailers including Walmart and Target appears to be putting downward pressure on consumer goods prices. Macklem indicates that BoC research suggests that this factor, not included its inflation model, may account for as much as 0.3% of the weakness in core inflation.

Good and Bad Disinflation

Macklem concluded his speech by acknowledging that the BoC cannot fully explain the weakness of CPI inflation, but that increased retail competition appears to be an important factor. He then argues that disinflation caused by retail competition is "Good Disinflation" and contrasts it with disinflation caused by weak aggregate demand which he refers to as "Bad Disinflation". With this distinction made, he argues that the BoC does not need to adjust monetary policy to resist Good Disinflation, which he believes will abate on its own over the next year or two. However, should there be a weakening in aggregate demand relative to the BoC's current expectations, then it would be appropriate for the Bank to respond by easing monetary policy.

This is a new twist for the BoC but is reminiscent of a distinction made several years ago between "Type 1" and "Type 2" exchange rate depreciations as a rationale for BoC inaction. That distinction was difficult to measure empirically and was eventually dropped.  

Implications

Tiff Macklem's final speech of his BoC career, in my view, is a model for how the Bank of Canada should communicate with markets and the general public. We can only regret that we won't have his clear communication in the future.

As to the implications for near term monetary policy, it seems clear that, for now, the BoC is willing to consider the 20-month period of below-target inflation as a case of "Good Disinflation", which does not require a monetary policy response in the form of an interest rate cut. I doubt that the Good vs. Bad Disinflation distinction will have any longer shelf life than Type 1 vs. Type 2 currency depreciation distinction did.

It is also clear, however, that the BoC lacks a full explanation of persistently below-target inflation. The BoC is wary that any further disinflationary shock could push inflation further below target and thereby risk "unhinging" inflation expectations to the downside. Should that occur, returning inflation to target could take considerably longer than six to eight quarter horizon over which the BoC aims to return inflation to the 2% target. Consequently, the BoC is unlikely to change its forward guidance, which Macklem expresses like this: "The timing and direction of the next change to the policy rate will depend on how new information influences [the] balance of risks." 

Good luck with your future endeavours, Tiff. You will be missed.    

Canadian ETF Portfolios: January Review and Outlook

In January, turmoil in emerging markets, some disappointing US economic data, and continued tapering of QE by the Federal Reserve coincided with a major selloff in global equity markets. Over-extended equity valuations have made the selloff more violent. US and most other DM bond yields posted a contrarian rally, as markets increasingly focused on deflationary forces emanating from key EM economies and the Eurozone. Evidence on US growth remained solid, but there were some important disappointments in January. The December US employment report posted a much weaker-than-expected gain of 74,000 payroll jobs, but the unemployment fell to 6.7% from 7.0%. The Citi US Economic Surprise Index, which had surged into early January, fell back considerably by the end of the month.

Middle East tensions remained subdued as the US-led tentative agreement with Iran over its nuclear program held together and despite the fact that Syria made very limited progress on destroying its chemical weapons and. Crude oil prices were weaker, as the WTI futures price traded down to $92/bbl in mid-January from its end-December level of $100/bbl, but rallied back to $98/bbl by January 31^st.

Gold prices rebounded, however, as turmoil in some notable EM economies (Turkey, Thailand, Argentine and Ukraine) spilled over into DM markets for risky assets and gold rose to $1240 after closing December at $1202. Gold and inflation-linked bonds, the worst performing assets of 2013, were among the best performing assets in January.

With crude oil weakening but gold prices rising, the Canadian dollar remained on a weakening trend. The Fed’s decision to proceed with tapering, combined with the Bank of Canada’s more dovish stance, contributed to a sharp weakening of the C$, which fell 4.4% against the US$ in January, with USDCAD rising to 1.113.

Global Market ETFs

Monthly Performance for January

EM turmoil and weaker US data dented sky-high equity market sentiment in January. The S&P500 hit a record closing high on January 15, but fell in the last two weeks of the month to close at 1783 down from 1842 at the end of December. Global equity ETFs posted negative returns in January. Most major markets declined in local currency terms, but given the weakness of the C$, Canadian investors saw mixed global equity performance in CAD terms. The weaker global equity ETFs included Emerging Markets (EEM), which returned -4.5% in CAD terms, Japan (EWJ)  -2.4%, and Eurozone (FEZ) -1.5%. Gainers included US (SPY), which was up +0.9% in CAD terms, US small caps (IWM) +1.6%, and Canada (XIU) +0.5%.

Commodity ETFs performed well in CAD terms. The Gold ETF (GLD) returned 8.1% in CAD terms, while the iShares GSCI commodity ETF (GSG) returned 2.3% as commodity price weakness was more than compensated for by C$ weakness. 

Global Bond market ETF returns were surprisingly strong in January, with DM bond ETFs outperforming EM bond ETFs by a wide margin. Canadian bonds (XBB) returned 2.4% in January. The best performance came from US bond ETFs which benefitted Canadian investors as bond yields fell and the C$ weakened. US long bonds (TLH) returned +8.8% in CAD terms. Non-US global government bonds (BWX) posted a return of 5.0% in CAD terms. Emerging Market bonds underperformed in January as USD-denominated bonds (EMB) returned +3.7%, while EM local currency bonds (EMLC) returned -0.02% in CAD terms as EM currencies weakened as capital was pulled out of EM assets.

Inflation-linked bonds (ILBs) posted a strong rebound in January. Canadian RRBs (XRB) returned +4.2%, US TIPs (TIP) returned +6.8% in CAD terms, and non-US ILBs (WIP) returned +3.3%.

US investment grade (LQD) and high yield (HYG) bonds also posted strong gains in CAD terms, returning 6.5% and 5.0% respectively. Canadian corporate bonds (XCB) returned 2.3%.

Global ETF Portfolio Performance for January 2014

In January, Canadian ETF portfolios more heavily weighted in Gold, US nominal bonds, and inflation-linked bonds, with limited or zero weight in EM assets performed best.

The traditional Canadian 60% Equity ETF/40% Bond ETF Portfolio gained 237bps in January, benefitting heavily from the currency gains on its unhedged foreign equity exposure. A less volatile portfolio for cautious investors, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned 116 bps.

Risk balanced portfolios, which were disappointing in 2013, performed very well in January. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs discussed above, gained 424bps in January. The strong returns in the levered risk balanced portfolio were attributable to strong gains in the leveraged positions of nominal and I-L bonds. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds and ILBs and more exposure to corporate credit, returned 348bps in January.

Outlook for February

The investment environment changed significantly in January and the near-term prospects contain substantial risks. Key developments that markets will be watching in February will include:

·   The US debt ceiling, which looked like a contained issue a month ago, takes on added importance in the current volatile market environment.

·   Over the past month, economic data have been mixed, but key data points including the December employment report and the January ISM report, released on Feb. 1, were much weaker than expected. Weather was a factor in both reports, and rebounds could follow. The US Economic Surprise Index was very strong in early January, but has fallen quite sharply since then. The US ISM Manufacturing PMI slumped to 51.3 in January from 56.5 in December, and the New Orders index collapsed to 51.2 from 64.4. At this stage, the US macro data is not providing a clear picture on the economy’ momentum.

·   Concerns about global deflation continued to rise, with warnings from the IMF and further soft inflation readings in the US, Eurozone, Asia and Canada. Failure of inflation to stabilize and move higher over the next few months could become an increasing concern for financial markets.

·   Emerging markets will remain a focus in financial markets. Financial conditions have tightened meaningfully in all EM countries and very sharply in countries like Turkey and Brazil. The Peoples’ Bank of China has moved to ease rising funding rates for banks, but this may be a symptom rather than a cure for China’s over-expansion of credit in the shadow banking system.

In this environment, industrial commodity prices remain under downward pressure in early 2014.  Copper prices have continued to edge down.

In a mid-January post on Inflation and Deflation Scenarios, I pointed to Russell Napier’s advice to watch inflation expectations (measured by break-evens), copper prices and credit spreads. In the short time since that post, each of these indicators have moved further toward the outcomes consistent with the deflation scenario. I noted at the time that Risk Balanced portfolios would perform best in the Deflation scenario and that it what happened in January. 

Last month, I concluded that “looking ahead to 2014, equities, credit and government bonds are all richly valued. As the Fed continues to taper the risk of a sharp equity market correction continues to loom. When such a correction begins, it remains likely that it will be triggered by a further sell-off in government bond markets and then spread into the credit and equity markets.”

That prognostication proved half-right. The equity market correction arrived, but it was EM tensions, some weaker than expected economic data, and growing deflation concerns the proved to be the trigger, not the further bond market sell-off that I and many others expected. How deep the current correction in risky assets becomes will depend on whether the concerns that triggered it multiply or diminish in the weeks ahead. The US employment report on February 7 will be the first test, but is unlikely to be decisive. The turmoil in EM, and China in particular, and further evidence on inflation dynamics will be more important.

Raising cash was a good strategy in January. If US equities, which broke key support levels on February 3, do not rebound to finish higher this week, raising cash will continue to be a good strategy. Putting that cash to work in top quality corporate bonds may be the best alternative until the situation becomes more settled.  

Inflation or Deflation: Implications for Portfolios

In a recent post on The Outlook for Global Inflation in 2014, I noted that the consensus forecast for global inflation appears to be the lowest on record. I also pointed out that while inflation is considerably lower in Developed Market (DM) economies than in Emerging Market (EM) economies, current inflation drivers are much stronger in DM than in EM. In that post I suggested that “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 global inflation could be higher in 2014 than the record low forecast”.

Subsequent to that posting, I read an insightful research note by the estimable Russell Napier of CLSA written in November 2013 entitled “An ill wind”. In the note, Napier argues that falling export prices from Japan, China and Korea constitute an ill wind from the East that will continue to blow in 2014 risking further declines in inflation in the US, Eurozone and other DM economies.

Napier’s note got me thinking that preferred portfolio allocation in 2014 will be very different in the scenario I outlined, in which inflation turns out to be higher than expected, than in as Napier's scenario, which anticipates an accelerating move toward deflation. As this post will explain, either upside surprises on inflation or a move toward deflation could have highly negative outcomes for equity-heavy portfolios.

 

Three Scenarios

A very useful contribution of Napier’s note is that he draws attention to three leading indicators to keep an eye on to help gauge which direction inflation is likely to take. He urges investors to watch TIPS-implied inflation (using 5-year breakevens), copper prices and corporate bond spreads, which he believes can give an early read on whether benign disinflation it tipping towards dangerous deflation.

I have put together three scenarios to illustrate three different inflation outcomes:

1.     higher-than-expected Inflation,

2.     the comfortable Consensus, and

3.     slide toward Deflation.

The scenario paths of US CPI inflation are show in the chart below. The comfortable Consensus expects US inflation to continue to fall in 1Q14 but then to rise modestly to 1.6% in 4Q14. In the higher than expected inflation scenario, stronger US growth against a reduced potential growth rate results in a quick move up in inflation to 2.5% by yearend. In the Napier-type deflation scenario, US inflation continues to drop well below 1% as 2014 unfolds.   

  

Under these three scenarios, inflation expectations as expressed in US TIPs Breakevens would unfold very differently as shown in the chart below.

 

Copper prices, which are very sensitive to growth and inflation expectations would also trace out very different paths in the three scenarios as depicted in the chart below, which shows expected copper price changes over the year.

Finally, corporate bond spreads would behave very differently under the three scenarios. Napier’s review of the behavior of the Baa corporate bond spread ahead of the stock market declines of 1998, 2001 and 2007-08 suggests that corporate bond spreads do tend to spike in deflationary episodes, but that they are not as timely a lead indicator as TIPs breakevens. Nevertheless, these deflationary experiences all saw spreads widen to more than 300 basis points.

Equity, Bond and Currency Markets

Markets would behave very differently in the three scenarios outlined above. I have relied on Napier’s research and my judgment of recent market correlations to come up with what I believe would be the likely outcomes for key equity (S&P500), bond (10-year US Treasury yield) and currency markets (the Canadian dollar exchange rate USDCAD), which are of particular importance to Canadian investors. The charts below trace out the likely paths of these key market indicators in the three different scenarios.

To summarize the likely market outcomes:

·   Consensus expects that with a modest rise in inflation in 2014, the S&P500 will post a decent gain of about 8% to close to 2000, the 10-year UST yield will continue to rise to 3.75% and Canadian dollar will end 2014 little changed with USDCAD at 1.06.

·  The Inflation scenario, which sees a rise in US CPI inflation to 2.5% this year, would see the S&P500 falling 10% to 1660, the 10-year UST rising to 4.15% and the Canadian dollar strengthening with USDCAD falling to 1.02.

·   In the Napier-like Deflation scenario, the S&P500 would likely face a drawdown of 25% at some point in 2014, while the 10-yr UST would fall back to 2.25% and the Canadian dollar would weaken sharply with USDCAD rising to 1.20.

Implications for Canadian ETF Portfolios

  

Asset class returns would vary quite dramatically across the three scenarios that I have sketched out. The chart below depicts the expected Canadian dollar total returns on the major asset class ETFs that I write about in this blog under each of the scenarios. The results indicate that investors are walking a tightrope between deflationary and inflationary outcomes. Let us hope that the Consensus proves close to the mark because the outcomes in both tails of the inflation probability curve are not good.

Given this set of ETF returns, how would different portfolio structures perform? The charts below show expected returns to four different portfolios that I regularly track under each of the three scenarios.

  

The Consensus scenario provides unexciting returns for Canadian investors. But after strong returns in 2013, this would not be a bad outcome. Equity and credit heavy portfolios will perform best if the Consensus proves accurate. Risk balanced portfolios that have larger weights in government nominal and inflation-linked bonds and commodities would underperform as they did in 2013, with the levered version of this portfolio structure performing worst.

  

The Deflation scenario would provide negative returns for Canadian investors if they were invested in conventional equity and credit-heavy portfolios. Such portfolios would be supported to some extent, however, if they have significant foreign content as Canadian dollar weakness would tend to temper losses on USD denominated ETF exposures to foreign stocks, credit and commodities. Global Risk Balanced portfolios would perform best in the Deflation scenario, as they would benefit from their larger exposure to government debt, which would benefit from falling 10-year UST yields. Inflation-linked bonds would underperform nominal bonds but would still provide positive returns. The Levered Risk Balanced portfolio would be the best performing structure in the Deflation Scenario, possibly reaching a double-digit return.

Finally, the Inflation scenario would be highly damaging to all of the portfolios. Equities, credit and nominal government bonds would all perform poorly in the event of significant upside inflation surprises that would hasten tapering of QE and bring forward expectations of central bank policy rate increases. Exacerbating these effects for Canadian dollar investors would be the effect of Canadian dollar appreciation. In fact, the portfolio that would perform best in this scenario would be the risk averse 45% Equity, 25% bond and 30% Cash portfolio, as the large cash position would mitigate the portfolio declines. The Levered Risk Balanced portfolio would be the worst performer as bond losses would be larger because of the large exposure to domestic and foreign nominal and inflation-linked bonds.

Conclusions

Looking at the three scenarios, one is struck by the continuing risks to investing in the post-financial-crisis environment which has been characterized by unconventional monetary policies that have encouraged investors to move into risky assets and led to rich valuations for equities, bonds and credit. Given these valuations, the Consensus macro scenario, in which the Fed tapers and gradually ends Quantitative Easing, would provide only moderate positive returns. If the current Consensus does not play out, as it usually doesn't, there are great risks to both the higher-than-expected Inflation scenario and the slide toward Deflation scenario sketched out by Russell Napier.

If one leans toward the higher-than-expected Inflation scenario, the preference would be the conservative 45% Equity, 25% Bond, 30% Cash portfolio.  If one leans toward the slide toward Deflation scenario, the preference would be the levered global Risk Balanced portfolio.

The most important takeaway from this analysis is the importance of taking a flexible approach and being prepared to make substantial asset mix shifts if the economy veers toward either the Inflation scenario or the Deflation scenario in 2014.

Canadian ETF Portfolios: December Review and 2014 Outlook

In December, stronger US economic data and the decision by the Federal Reserve to begin to taper its massive QE program provided a further boost to equity markets and pushed US bond yields to new 5-year highs. Many strategists remain cautious toward equities based upon over-extended valuations, but expect equities to continue to outperform bonds in 2014. Evidence on US growth continued November’s improvement by surprising on the positive side in December. The November 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 remained subdued in the wake of the Russia-led agreement committing Syria to destroy its chemical weapons and the US-led tentative agreement with Iran over its nuclear program. Crude oil prices rebounded, as the WTI futures price recovered to $100/bbl at the end of December from its November low of $92.

Gold prices continued to weaken, however, as concerns that the Fed would proceed with tapering of QE proved correct and gold fell to $1202 at the end of December, after closing November at $1251. Gold and inflation-linked bonds continued to be the worst performing assets of 2013.

Despite the rebound in crude oil prices, the Canadian dollar continued to weaken. The Fed’s decision to proceed with tapering, combined with the Bank of Canada’s more dovish stance on tightening, contributed to weakening the C$, which fell 0.3% against the US$ in December, with USDCAD rising to 1.0641.

Global Market ETFs

(i) Monthly Performance for December

Stronger US data seems to have been ample justification for the Fed to begin tapering and global equity markets reflected this growth optimism. The S&P500 hit a record closing high of 1848 on December 31. Global equity ETFs posted solid returns again in December led by Eurozone (FEZ), which returned +2.8% in CAD terms, US (SPY) +2.3%, Japan (EWJ) +0.9%. US small caps (IWM) returned 1.9%. Canada (XIU) underperformed, returning 0.9%, despite the rebound in crude oil prices. Emerging Market equities (EEM) performed poorly as the taper began (as they did in the spring), returning -1.0% in CAD terms.

Global Bond market ETF returns were mostly negative in December as growth optimism and the Fed’s decision to taper weighed on prices. Canadian bonds (XBB) fell for a second straight month, returning -0.6% in December. US long bonds (TLH) returned -2.1% in USD terms but with the weakening of the C$, the return was -1.8% in CAD terms. Non-US global government bonds (BWX) fared better, posting a return of -0.2% in CAD terms. Emerging Market bonds outperformed in December as USD-denominated bonds (EMB) returned +0.2%, but EM local currency bonds (EMLC) returned -0.5% in CAD terms as EM currencies weakened on the tapering news.

Inflation-linked bonds (ILBs) once again were to be avoided in December. Canadian RRBs (XRB) returned -2.2%, US TIPs (TIP) returned -1.2% in CAD terms, and non-US ILBs (WIP) returned -0.5%.

US investment grade (LQD) and high yield (HYG) bonds posted meager gains in CAD terms, both returning 0.2% in December. Canadian corporate bonds (XCB) underperformed with a return of -0.5%.

 Annual ETF Returns for 2013

The year began with the US fiscal cliff being narrowly avoided as US lawmakers agreed to extend the deadlines for the US Debt Ceiling and government shutdown. As 1Q13 unfolded, it became clear that without a deal, an end to Bush tax cuts for high income earners, an end to the payroll tax cut, and “sequestration” of US government spending would automatically kick in. The Fed, fearing that the fiscal drag entailed by these changes would stall the economy, made it clear that its open ended quantitative easing would remain in place. As the economy fared somewhat better than expected, investment returns got off to a good start in 1Q13. In May, Fed Chairman Bernanke surprised markets by suggesting that the Fed could begin tapering within months, setting off a sharp sell-off in global markets. Bernanke and other FOMC members provided reassurances that tapering was not tightening, but the markets remained unconvinced as growth struggled through mid-year. By early September, the consensus view was that the taper would begin at the September FOMC meeting, but the Fed surprised again by announcing that it would continue to purchase $85 billion of bonds per month. In 4Q13, US economic data showed some improvement and despite inflation running well below the Fed’s desired, the Fed announced that it would reduce its bond purchases to $75 billion in January 2014.

In this 2013 environment of sluggish but improving US growth, weak inflation, and large scale Fed bond purchases, global short-term interest rates remained at very low levels, with real rates (after inflation) negative in most developed countries. DM central bank policies, including Abenomics in Japan, represented unprecedented stimulus for a global economy that was in its fourth year of a weak economic recovery. Investors responded to global policy actions, by reaching for higher yields and avoiding near zero cash returns. This meant that money continued to flow into equities and higher yielding corporate bonds. With inflation subdued and the Fed promising to end QE, gold, inflation-linked bonds, and emerging market currencies performed very poorly. The chart below shows annual returns for Global Market ETFs in Canadian dollar terms.

In 2013, the best global ETF returns for Canadian investors were in US and other global equities. The S&P500 rose 26.9% for the year. This resulted in a total return (assuming dividend re-investment) on the S&P500 ETF (SPY) of 32.3% in USD terms and 38.0% in CAD terms. On the same basis, the iShares unhedged Japan equity ETF (EWJ) returned +31.1%, while the hedged iShares Canada ETF (CJP) returned a stunning 55.9%. The SPDR Eurozone equity ETF (FEZ) returned +30.9% in CAD terms. US small caps (IWM) returned 41.7%, outperforming the large cap SPY. Canada (XIU) lagged these foreign equity ETFs badly returning 9.9% in 2013. Emerging Market equities (EEM) were the weakest as Fed tapering fears led to capital outflows and weaker currencies, resulting in a -1.2% return in CAD terms.

Commodity ETFs performed poorly. The Gold ETF (GLD) returned -27.4% in CAD terms, while the iShares GSCI commodity index returned -0.6%.  

Global Bond market ETF returns were weak but mixed in 2013. Foreign bond ETFs benefited from currency strength relative to the Canadian dollar. As bond yields rose in anticipation of tapering, the DEX Universe Canadian bond ETF (XBB) returned -1.4% in 2013, while the Canada Long Bond ETF (XLB) posted a serious loss of -9.9%. US long bonds (TLH) returned -6.5% in USD terms, but with the weakening of the C$, this translated into a -2.5% return in CAD terms. Non-US global government bonds (BWX) fared better, posting a return of +0.3% in CAD terms. Emerging Market bonds suffered from the same problems as EM equities. USD-denominated EM bonds (EMB) returned -2.6%, while EM local currency bonds (EMLC) returned -6.2%.

Inflation-linked bonds (ILBs) were a major casualty of the combination of unexpectedly low inflation and tapering anticipation in 2013. The Canadian real return bond ETF (XRB) was the worst performer, returning -14.1%. US TIPs (TIP) returned -10.0% in USD terms, but thanks to USD strength, lost just 5.1% in CAD terms. Non-US ILBs (WIP) fared better, returning -1.7% in CAD terms.

In corporate bond space, the US high yield bond ETF (HYG) posted a solid return of 11.0% in CAD terms in 2013, while the US investment grade bond ETF (LQD) returned 2.3%. The Canadian corporate bonds ETF (XCB) eked out a return of +0.9%.

Global ETF Portfolio Performance for 2013

Over the course of 2013, Canadian ETF portfolios more heavily weighted in foreign equities and high yield bonds, with limited or zero weight in commodities and inflation linked bonds performed best.

The traditional Canadian 60% Equity ETF/40% Bond ETF Portfolio gained 93bps in December, bringing its YTD return up to 16.1%. A less volatile portfolio, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, returned a very competitive 14.0%.

Risk balanced portfolios, which performed well in recent years, were disappointing in 2013. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs discussed above, lost 49bps in December, lowering its YTD return to 1.8%, after it suffered a severe 8.1% drawdown from April 26 to June 21 during the “taper tantrum” selloff. The weak returns in the levered risk balanced portfolio were attributable to the sell-off in the leveraged positions of Canadian nominal and I-L bonds. An Unlevered Global Risk Balanced Portfolio, which has less exposure to government bonds and ILBs and more exposure to corporate credit, returned 43bps in December, raising its YTD return to 9.3%.

Expectations for 2014

The New Year will undoubtedly bring a new set of surprises for global markets. Key developments that markets will be watching will include:

·   Global growth forecasts for 2014 were marked down from July through December. Forecasters are still relatively optimistic that DM economies will grow faster in 2014 than in 2013, while EM economies are expected to slow further in the year ahead. 

·   Over the past month, US economic data have been stronger than expected. The Citi US Economic Surprise Index rose from -4 in early November to +50 in late December. The US ISM Manufacturing PMI eased down to 57.0 in December from 57.3 in November. While the high level if the ISM indicates a pickup in manufacturing activity in early 2014, it is often better to sell equities at high ISM readings than to buy them.

·   Globally, inflation fell to the lowest readings since the Financial Crisis in Q413. Consensus forecasts for 2014 inflation are the lowest on record. This means that any uptick in inflation this year will be a negative surprise for financial markets.

·   DM central banks, which have focused heavily on supporting stronger recoveries and reducing output gaps, are seeing positive signs on this front. While stronger growth may lead markets to believe that the Fed and other central banks will reduce monetary stimulus sooner, if this is combined with an unexpected uptick inflation, the reaction in the bond and equity markets is likely to be quite negative.    

In this environment, we will keep close watch on commodity prices early in 2014.  Global excess supply has weighed on oil prices and Fed tapering has been kryptonite to gold. A pickup in growth could see commodities -- the dogs of 2013 -- stage a recovery in early 2014.

Last month, I concluded that, “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 …

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”.

This proved correct. But looking ahead to 2014, equities, credit and government bonds are all richly valued. As the Fed continues to taper, the risk of a sharp equity market correction continues to loom. When such a correction begins, it is likely that it will be triggered by a further sell-off in government bond markets and then spread into the credit and equity markets.