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.

  

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.  

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. 

Conclusions

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. 

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. 

The Outlook for Global Growth in 2015

It's that time of year to look ahead to the prospects for global growth. I posted a similar outlook a year ago and recently followed up with an assessment of those 2014 forecasts. I should be clear about why I find this exercise useful. I assemble a global growth outlook not because I have faith in forecasts. I do it because I'm looking for a "consensus view" on the year ahead, a view that is presumably already built into market prices. The consensus view, as Howard Marks of Oaktree Capital recently reminded us, is "what 'everyone knows' [and] is usually unhelpful at best and wrong at worst". What will move markets in 2015 is not the current consensus forecast, but the ways in which actual growth diverges from that consensus.

With the foregoing caveat in mind, there are four things to know about the outlook for global growth:

• 2015 growth forecasts have edged down over the past year;
• 2015 growth is currently expected to be better than 2014; 
• Most DM economies are expected to grow above trend, while most EM economies are expected to grow below trend;
• Leading indicators suggest somewhat slower growth than forecast for most countries.

2015 Forecasts have Edged Down

Last year at this time, global growth was expected by the IMF to pick up to 3.8% in 2014 while JP Morgan economists expected a more modest acceleration to 3.3%. Instead, 2014 growth is now estimated to have remained flat at the same disappointing 3.0% pace as in 2013.

The focus of economists now is on growth forecast for the year ahead, but it is worth noting that views on 2015 growth have edged down over the past year. 

This year, forecasters tell us once again that global growth will pick up in 2015 to 3.8% (IMF October forecast), or to 3.5% (Barclays December forecast), or to 3.3% (JPMorgan December forecast). These forecasts are presented as upbeat news, but the reality is that the 2015 forecast for has faded from the 4.0% forecast published by the IMF in July 2014.

2015 growth expected to be stronger almost everywhere

As was the case last year,  growth is expected to pick up in most countries in 2015. Economies with the largest forecast growth pickup include Japan (1.4% in 2015 vs 0.2% in 2014), Mexico (3.2% vs 2.2%), Eurozone (1.6% vs 0.9%), US (3.0% vs 2.3%) and India (6.0% vs 5.3%). Modest growth improvements are also expected in Australia and Korea. In Canada, 2015 growth is expected to match the 2014 pace of 2.4%.

Growth is expected to slow in UK (2.8% vs 3.0%) and China (7.2% vs 7.4%), while Russia is expected to fall into recession (-3.3% vs +0.6%).

Once again: DM above trend, EM below trend

While global growth is expected to be a bit stronger in 2015, the divergence between DM and EM growth performance is expected to continue. EM growth is consistently higher than DM growth, but the important divergence is that DM economies are expected to grow above their trend (or potential) rate of growth, while EM economies are expected to grow below their trend rate. In the chart below, the blue bars show the 2015 growth forecast versus the OECD estimate of the trend growth rate for each economy.

In 2015, the larger DM economies are expected to grow at an above trend pace, while Australia is expected to grow at trend. In contrast, all of the major EM economies, except Mexico (0.3% above trend), are expected to grow well below trend, especially Brazil (3.0% below trend) and Russia in recession (6.5% below trend, off the chart). 

Leading indicators support most growth forecasts

In the chart above, the red bars show the latest OECD composite leading indicators (CLIs) versus trend for each of the economies. These CLIs generally support weaker 2015 growth than economists are forecasting, with a few exceptions.

In the DM economies, the leading indicators suggest that growth could surprise on the downside in US, Japan and Canada.

In the EM economies, CLIs suggest that growth could be weaker than expected in China and Mexico, but stronger than expected, although still below trend, in India, Brazil and Russia. Korea is an exception, where the CLI suggests strong above-trend growth.

Conclusions and Questions

2014 turned out to be a year in which global growth was modestly disappointing, but the real story for markets was the divergences in real GDP growth. Will the divergences of 2014 continue? If so, the US Fed and the Bank of England will likely begin to tighten monetary policy in 2015, while the ECB, BoJ and PBoC will likely maintain their current accommodative policies or ease further. In such a scenario, the US$ is likely to continue to appreciate against most of the world's currencies. An appreciating US dollar combined with below trend growth in China and other EM economies is negative for commodity prices and for commodity exporting countries and their currencies. 

The questions one should ask about 2015 forecasts are these: 

• Can the macro divergences in the global economy be sustained without creating serious financial instability and in some countries and significant volatility in global currency and financial markets? 
• Can the low growth, highly-indebted Eurozone economies and Japan sustain stronger growth with super-accommodative monetary policy but without major economic reforms? 
• Can China navigate a soft landing of its over-leveraged economy?  
• Can Canada and Australia, with overheated housing markets, continue to grow at or above trend after a sharp fall in commodity prices and as the Fed begins to raise its policy rate? 
• Will we look back on 2015 as yet another year that started with optimistic forecasts and ended with disappointment? 

My tentative answers to these questions are: No, No, Don't Know, Unlikely, and Probably. As was the case last year, 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. 

Global Macro Misses: Biggest Forecast Errors of 2014

Economic and market forecasting is a mug's game. But that doesn't stop economists and strategists from making forecasts. At this time of year, I use a variety of sources to assemble a consensus view of economic and market outcomes for the year ahead. The turn of the year is always peak season for marketing investment themes based on year ahead forecasts. I'll review 2015 forecasts in a forthcoming post, but first, lets take a look back at 2014. In particular, let's look at the notable global macro misses and the biggest forecast errors of the year.

Real GDP

I have mentioned in previous posts that, since the Great Financial Crisis, forecasters have tended to be over-optimistic in their real GDP forecasts. That was true again in 2014. In the twelve major economies we track, real GDP growth fell short of forecasters' expectations in seven and exceeded expectations in just two countries. The weighted average forecast error was -0.3 percentage points.

Current estimates of real GDP growth for the two largest economies, the US and Eurozone, fell short of forecasts by 0.2 pct pts. The biggest misses were for  Brazil (-1.9 pct pts), Japan (-1.3), Russia (-1.2) and Mexico (-1.2). Canada and India beat forecasts by 0.3 pct pts and China by 0.1. On balance, it was a fourth consecutive year of global growth trailing expectations.

CPI Inflation

Inflation forecasts for 2014 were also too high. Six of the twelve economies are on track for lower than forecast inflation, while inflation will be higher than expected in five countries. The weighted average forecast error was -0.8 pct pts, a significant miss highlighting the disinflationary pressures that continue to dominate across the global economy. 

The biggest downside misses on inflation were in Emerging Asian economies including India (-3.4 pct pts), Korea (-1.9) and China (-1.7). These countries were joined by big DM economies including UK (-1.3), Eurozone (-0.9) and US (-0.4). The upside misses on inflation were in countries that experienced large currency depreciations, including Russia (+4.8), Brazil (+0.6) and Mexico (+0.4).

Policy Rates

Economists' forecasts of central bank policy rates were close to the mark for DM economies, but there were some notable misses for EM economies. In the DM, the ECB and the BoJ made small policy rate cuts that were not expected a year ago. 

The misses on central bank policy rates for there emerging economies were mixed. The biggest misses were for Russia, which is literally off the charts, at +11.5 percentage points, and Brazil at +2.3 pct pts, both economies where the currencies suffered sizeable depreciations. In emerging economies where inflation surprised to the downside and currencies were firm, the central banks cut their policy rates more than expected, as in Korea -0.50 pct pts and China -0.40.

10-year Bond Yields

In 10 of the 12 economies, 10-year bond yield forecasts made one year ago were too high. The deflationary forces at work in the Eurozone and China pulled 10-year yields down almost everywhere compared with forecasts of rising yields.

In all of the DM economies we track, 10-year bond yields surprised strategists to the downside. The weighted average forecast error was -1.10 percentage points. The biggest misses were in the Eurozone (-1.57), Australia (-1.54), UK (-1.37), Canada (-1.04) and US (-0.92). The only exception to the downside misses was Russia, which again was off the chart, with an upside surprise of 5.65 pct pts.

Exchange Rates

The strength of the US dollar surprised forecasters.  To be fair, the USD was expected to strengthen against most currencies, but not by nearly as much as it did. On a weighted average basis, the 11 currencies depreciated versus the USD by about 6.5% more than forecast a year ago.

The USD was expected to strengthen because many forecasters believed the Fed would begin to tighten by the end of 2014. While the Fed has been edging toward tightening this year, it has found various reasons to delay, with tightening now not expected to begin until mid to late 2015. If everything else had been as expected, this would have tended to weaken the USD. But everything else was far from as expected. The ECB, the BoJ, and even the PBoC eased monetary policy, something no economist forecast a year ago. On top of that, oil prices collapsed and other commodity prices weakened so that commodity currencies like RUB, MXN, CAD and AUD weakened more than forecast.

The biggest FX forecast miss was, not surprisingly, the RUB, which again was off the charts, more than 40 percentage points weaker than forecast a year ago. Other big misses were for MXN (-15.2 pct pts), BRL (-11.0), CAD (-10.6) and AUD (-8.6). GBP was the only currency that depreciated less than forecast versus the USD.

Investment Implications

The investment implications of the 2014 forecast misses were substantial. First, global nominal GDP growth was about a full percentage point weaker than expected, reflecting downside forecast errors on both global real GDP growth and global inflation. This would normally be bad for equity markets, but the weaker nominal GDP and profits growth was offset by easier than expected global monetary policy. US equities performed well in this environment, as did markets where central banks provided unexpected easing. Second, the downside misses on growth and inflation and the central banks' responses resulted in a strong positive returns on government bonds, the opposite of what the majority of strategists forecast. Third, divergences in growth, inflation and central bank responses, along with the sharp declines in crude oil and other commodity prices, led to much larger currency depreciations versus the USD than forecast. For Canadian investors, this meant that investments in both US equities and US government bonds, leaving the currency exposure unhedged, were big winners.

Poloz Should Ignore the OECD

The Bank of Canada will make its final policy rate announcement of 2014 on December 3. No one expects BoC Governor Stephen Poloz and the Bank's Governing Council to make any change in the policy rate. It has been set at 1% since former BoC Governor Mark Carney completed a sequence of three 25 basis point rate hikes between May and September 2010.

It should be noted that none of the other major central banks -- the US Fed, the ECB, the Bank of England, or the Bank of Japan -- raised their policy rates at that time (although the ECB did make that mistake in 2011). Indeed, each of those central banks have further eased monetary policy, either by reducing their policy rate or by expanding their balance sheets through quantitative easing (QE) since 2010. It is as if, in the monetary policy race, the Bank of Canada made a false start and stopped, while the other central banks ran the other way!

Governor Poloz and his council do not make their decisions without considering what other central banks are doing. It cannot have escaped their attention that two of the major central banks, the BoJ and the ECB, are battling deflation pressures. The BoJ launched the most aggressive QE program to date in 2013 and just added another substantial dose at the end of October as it became clear that Japan had dipped back into recession. The ECB has introduced a negative deposit rate and promised to broaden its QE. The Fed ended its QE program in November and, along with the BoE made noises this summer about raising the policy rate in 2015. But with the recent drop in oil prices and general global inflation pressures, both Fed Chair Janet Yellen and BoE Governor Mark Carney have reassured markets that no early tightening is being contemplated.

But, OMG! Canada just reported that the total CPI inflation rate in October was 2.4% and the Core CPI inflation rate was 2.3%, both above the mid-point of the 1-3% target range.

Inflation hawks, like the economists at the OECD, are recommending that the BoC should begin another round of policy rate hikes within six months. Well, that would be a mistake!

Since the beginning of 2008, Canada's total CPI Inflation rate has averaged 1.64%, well below the mid-point of the 1-3% target band. Eighty percent of that time, the core CPI inflation rate has been below 2%. If the Bank of Canada had hit the 2% midpoint of the target range since 2008, the total CPI would be 2.1% higher than it is today. That means that over the past seven years, the CPI has fallen a full year behind the target.  

Recently, all major advanced economies have averaged growth well below their estimated potential. The chart below shows how much actual real GDP growth in the major economies has fallen short of the IMF's estimates of potential growth.

Since 2007, growth in Japan and Canada has fallen 3% short of potential, while the gap is -3.6% for the US, -4.8% for the UK and -6% for the Eurozone. Is it any wonder that the global economy is facing deflation pressures? As a consequence, most central banks remain focused on providing monetary accommodation or, at least, are reluctant to tighten policy.

Canada's monetary policy is already significantly tighter than those of the other major central banks. One way to see this is to look at current real policy rates, defined as the current policy rate minus the currently expected rate of inflation in 2015.

By this measure, the BoJ is the most aggressive central bank in fighting deflation (not even considering the impact of its massive QE program). The US Fed and the BoE remain highly accommodative. The ECB and BoC have the least stimulative real policy rates.

Canada's inflation rate has been pushed up temporarily by the recent depreciation of the Canadian dollar, which has pushed up prices of some imported goods including clothing. But there is still substantial slack in the economy. Gasoline prices have fallen and a likely to remain lower. The weakness in the Canadian dollar is an appropriate response the the drop in Canadian commodity prices and the weakening in Canada's terms of trade. A temporary rise of inflation is both a necessary and desirable consequence of the currency weakness for a country that has persistently undershot its inflation target for seven years.

Governor Poloz should ignore the OECD and resist the temptation to react to an upward blip in the inflation rate. He should follow the path taken recently by BoE Governor Carney, not the path taken in 2010 by then-BoC Governor Carney.