Global ETF Portfolios: 2Q15 Review and Outlook

Global ETF portfolios for Canadian investors gave back a lot of their first quarter gains in 2Q15. The weaker performance was partly attributable to a 1.6% appreciation of the Canadian dollar relative to the USD that reduced C$ returns for Canadian investors in USD denominated global ETFs.

Global economic developments were mixed but, once again, generally disappointing:

• The forecast for global growth in 2015 continued to be revised down.   
• Global real GDP growth in 1Q15 fell to its weakest pace since the 2008-09 global recession. Four of the eleven large economies that I track contracted in 1Q15, including US, Canada, Brazil and Russia. The US is on track for a moderate growth rebound in 2Q15, but the other three economies are still contracting. Following decent starts to the year, Eurozone and Japan growth moderated in 2Q15.  
• Crude oil prices stabilized and posted a modest recovery, supporting the currencies of oil exporting countries, including Canada.
• Inflation forecasts stabilized in 2Q15 as oil prices recovered and deflation worries eased.
• Despite the US Fed still signalling that it intends to begin raising the policy rate this year, global central banks continued to ease policy. China, Korea, Australia and Russia cut their policy rates in 2Q15. Brazil was again forced to hike policy rates to support its currency. 
• After falling virtually everywhere in 1Q15, bond yields reversed course and rose virtually everywhere in 2Q.
• In the final weeks of 2Q, after surging into bubble territory, China's equity market entered a sharp correction, falling by over 20% from its highs.
• In the final days of 2Q, negotiations between Greece and its official creditors broke down and Greece defaulted on a 1.6 billion Euro payment to the IMF. As 3Q begins, with Greek banks closed, capital controls looming, and a referendum planned for July 6, the situation remains fluid.

Despite reduced growth prospects and below target inflation, the Fed continued to stress the need for "policy normalization". In late June, New York Fed President William Dudley said that a September rate hike is still very much in play. Importantly, the Fed continues to signal that the normalization of rates will be gradual and dependent on incoming economic data. This caution has taken some of the steam out of the US dollar appreciation.

The Bank of Canada failed to follow up on a January rate cut with additional easing, judging that the negative shock to growth and inflation from weaker crude oil prices was faster but not larger than anticipated. This judgement was challenged by the June 30 release of April real GDP data showing a fourth consecutive monthly decline and rekindling speculation that another easing move is needed. The Canadian dollar, which had firmed versus the USD on moderately higher crude oil prices, was weakening again as 2Q came to a close.

Global Market ETFs: Performance for 2Q15

In 2Q15, with crude oil prices recovering and the USD weakening 1.6% against the CAD, the best global ETF returns for Canadian investors were in commodity and Japanese equity ETFs. The worst returns, driven by rising bond yields, were in US government and investment grade corporate bonds and Eurozone equities. The chart below shows 2Q15 and year-to-date returns, including reinvested dividends, for the ETFs tracked in this blog, in CAD terms.

In CAD terms, 17 of 19 ETFs posted losses, while just 2 posted a gain.

The gains were in the commodity ETF (GSG), which returned 6.6%, and the Japanese equity ETF (EWJ), which returned 0.7% in CAD.

The worst losses were in US Investment Grade bonds (LQD) -5.6%; US 10-year Bonds (TLH) -5.1%; and the Eurozone equity ETF (FEZ) -5.1%.

Canadian ETFs performed poorly in 2Q15. The Long Bond ETF (XLB) returned -4.4%; the Real Return bond (XRB) -3.9%; the Corporate bond (XCB) -1.3%; and Canadian equities (XIU) -2.0%.

Global ETF Portfolio Performance

In 2Q15, the Canadian ETF portfolios tracked in this blog all posted negative returns in CAD terms when USD currency exposure was left unhedged. When USD exposure was hedged, the portfolios generated flat to modestly positive returns. 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 lost 2.3% in CAD when USD exposure was left unhedged, but just lost just 1.6% 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, lost 1.8% if unhedged, but lost just 1.0% if USD hedged.

Risk balanced portfolios underperformed in 2Q15. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, lost 4.2% in CAD terms if USD-unhedged, but lost just 2.5% 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, lost 2.4% if USD-unhedged, but just 1.3% if USD-hedged.

Despite their 2Q15 losses, all of the global ETF portfolios retain decent gains for the year-to-date, ranging from a high of 7.4% for the Levered Risk Balanced Portfolio to a low of 4.3% for the conservative 45/25/30 portfolio.

Recent Performance in Perspective

The weak 2Q15 performance of the unhedged global ETF portfolios was been driven by two factors: the rise in bond yields as US economic data firmed and the Fed continued to tilt toward tightening; and the modest rebound of the CAD versus USD as the price of crude oil recovered. Both of these moves represented partial reversals of trends that generated strong 1Q15 returns (in CAD terms) for our global ETF portfolios. It is interesting question as to whether the 2Q15 reversals have run their course or will continue.

In its June Oil Market Report, the International Energy Agency noted that preliminary data indicate that crude oil inventory builds continued into the second quarter. Global supply and demand balances suggest that the pace of builds is not expected to slow until 3Q15 when supply growth is projected to be reined in. Crude oil inventories remain near record levels and oil production continues to run ahead of demand. The market also has been awaiting the outcome of the Iran nuclear negotiations ahead of a missed June 30 deadline that has now been extended. An agreement could put 1 million barrels of Iranian crude back on the market, but failure would spark renewed tensions.  

Fed and BoC policy continue to tilt in opposite directions. In both countries, real GDP contracted in 1Q15. While US economic data has firmed in 2Q, Canada has continued to stumble as the negative effects of lower crude oil prices continue to weigh on economic activity. While the Fed has remained steadfast that policy rate normalization will begin later this year, the BoC has taken a wait-and-see approach since cutting its policy rate in January. The US economy remains better positioned than Canada for a 2H15 rebound and influential members of the FOMC continue to signal the possibility of a rate hike as soon as September. 

Three months ago, I said "If growth disappoints in both countries as 2Q unfolds, however, it is likely that the Fed response will just be to delay tightening, while the BoC response will be to cut rates again." As 3Q15 begins, that seems to be the scenario that is playing out. For that reason, maintaining unhedged exposure to global ETFs remains my preferred portfolio stance.

The more conservative 45/25/30 portfolio (which I have favoured) incurred smaller losses in 2Q15 than the more aggressive 60/40 and Risk Balaced portfolios. As we enter 3Q15 in a continuing uncertain environment, characterized by sluggish global growth and divergent central bank policies, and with rich valuations for US equities, remaining well diversified with an ample cash position continues to be a prudent strategy.

Equilibrium Real Policy Rates: Does Anybody Really Know?

While most market participants and strategists focus on when the first Fed tightening will happen, the more interesting question is where should policy rates be now and over the next few years. While it has made virtually no headlines, the debate on the "equilibrium real policy rate" has picked up in recent months. It is one of those debates which is impossible to win, but is very important to understand. 

Ms. Yellen's View of the Equilibrium Real Policy Rate

My interest in the debate began with comments made by Fed Chair Janet Yellen in a speech on March 27, "Normalizing Monetary Policy: Prospects and Perspectives" (see here), which laid out the FOMC's views on policy rate normalization. In particular, Ms. Yellen argued that while the original Taylor Rule suggests that the Fed Funds rate should already be in the neighbourhood of 3%:

"Under assumptions that I consider more realistic under present circumstances, the same rules call for the federal funds rate to be close to zero."

The Taylor Rule, as expressed by Ms. Yellen, is the following:

The current policy rate (R) should = the equilibrium real policy rate (RR*) + core inflation (π) + 0.5 * the gap between current inflation and target inflation (π - π*) +      0.5 * output gap (y).

Under the original Taylor Rule, the equilibrium real policy rate was assumed to equal 2% (roughly the average historical value of the real federal funds rate). With core inflation at about 1.25%, the inflation target assumed to be 2%, and the output gap close to zero (assuming full employment at the current US unemployment rate of 5.5%), the original Taylor rule calculation would indicate that the current policy rate (Fed Funds Rate) should be 2.875% (or 2% + 1.25% - 0.375% - 0%).

But Ms. Yellen argued that "more realistic" assumptions are that the equilibrium real policy rate is equal to 0% currently (as some statistical models suggest) and that the US output gap is -1%, based on the assumption that full employment is reached at 5% unemployment and the Okun's law calculation that y = -2* (U - U*). Hence, using the Yellen assumptions plugged into the Taylor Rule equation, the current policy rate should be 0.375% or (0 + 1.25 - 0.375 - 0.5). Indeed, using statistical model that she refers to (the Laubach-Williams model), which yields a most recent estimate of the equilibrium real policy rate of -0.165%, the Yellen estimate of the appropriate Fed Funds rate currently is 0.21%, or pretty much exactly where it is. 

Why Has The Equilibrium Real Policy Rate Fallen?

A pioneer of the study of the equilibrium real policy rate is John C. Williams, the current president and CEO of the Federal Reserve Bank of San Francisco. Williams calls this the Natural Rate of Interest, which he defines as "the real federal funds rate consistent with the economy operating at its full potential once transitory shocks to aggregate supply or demand have abated". It is no surprise that Janet Yellen uses an almost identical definition of the equilibrium real policy rate as "the level of the short-term interest rate, less inflation, estimated to be consistent with maximum employment and stable inflation in the long run, assuming no future disturbances to the economy". 

In a March 2 speech titled "The Decline in the Natural Rate of Interest" (see here), Williams laid out his estimates of how the natural rate, i.e. equilibrium real policy rate, has evolved and why it has declined sharply in recent years. The chart below shows how Williams' estimate of the natural rate has evolved. 

In 1990, the equilibrium real policy rate was estimated to be 3.4%. By 2007, on the eve of the Great Financial Crisis, it had fallen to 2.1%. Following the crisis, it fell below 0% and has hovered there ever since, with the 4Q14 estimate at -0.2%. 

The Williams-Laubach model estimates the equilibrium real policy rate as a function of the potential or trend real growth rate of the economy and other unspecified factors (which include demographics, fiscal policy, private sector leveraging or deleveraging, and technological change). In the 1990 to 2007 period, the model estimates that of the 1.3 percentage point drop in the equilibrium real policy rate, 0.5% was contributed by the decline in trend growth and 0.8% was contributed by other factors. In the 2007-14 period, the model estimates that of the 2.3 percentage point drop in the equilibrium real policy rate, half of the drop was contributed by the decline in trend growth and half by other factors.

What about Canada?

While there is no equivalent to the Williams-Laubach model for Canada, it seems clear that the same forces that Williams contends have lowered the US equilibrium real rate have also lowered that rate in Canada.

A February 2015 paper by Hamilton, Harris, Hatzius and West (HHHW, see here) provided data on real GDP growth rates and real policy rates for a wide range of developed economies.

Average real growth rates fell in all of the countries shown in the 2004-14 period compared with the previous ten year period. Similarly, average real policy rates fell in every country except Japan, where deflation resulted in a higher real policy rate. Based on their review of the cross country data, HHHW drew three conclusions:

1. There is substantial uncertainty about the level the real equilibrium policy rate and its relationship with trend GDP growth is more tenuous than widely believed. 
2. Econometric analysis using cross-country data and going back to the 19th century supports a wide range of plausible central estimates for the current level of the equilibrium rate, from a little over 0% to the pre-crisis consensus of 2%. 
3. The uncertainty around the equilibrium rate argues for more “inertial” monetary policy than implied by standard versions of the Taylor rule.

Given these cautionary conclusions, what might the Bank of Canada be thinking about the appropriate policy rate now and in the medium term future?

To attempt to answer this question, we can do the Janet Yellen type calculations for Canada. Since Ms. Yellen will be the Chair of the Fed from now through the medium term, we can assume that her thoughts on the US equilibrium real policy rate will be quite influential (as well as being supported by San Francisco Fed President Williams). Some statements from Bank of Canada Governor Poloz seem quite sympathetic to Ms. Yellen's assumptions and conclusions.

For Canada, using the original Taylor Rule, the equilibrium real policy rate is assumed to equal 2%. With core inflation judged by the Bank of Canada to be about 1.7% and the output gap calculated by conventional methods estimated to be -0.5%, the original Taylor rule calculation would indicate that the current policy rate (Fed Funds Rate) should be 3.4% (or 2% + 1.7% - 0.15% - 0.25%).

But using "more realistic" assumptions, along the lines of those used by Ms. Yellen, that the equilibrium real policy rate is close to 0% currently and that the Canadian output gap is -1.5%, the current policy rate should be 0.80% or (0 + 1.7 - 0.15 - 0.75), or pretty much exactly where it is. 

Let's sum this up by saying that according to the original Taylor Rule, current policy rates in the US and Canada should be 2.875% and 3.4%, respectively. However, using the "more realistic" (or, if you like, "more dovish") assumptions that flow from the analysis of real equilibrium policy rates and larger estimates of the output gap, current policy rates in the US and Canada should be 0.2% and 0.8%, respectively, or pretty much exactly where they are.

Where will the Equilibrium Real Policy Rate Go Now?

In her March speech, Fed Chair Yellen expressed optimism that the equilibrium real Fed Funds rate will rise gradually as headwinds to growth diminish and the economy strengthens. Accordingly, if the equilibrium rate is rising over time, the "neutral" setting of monetary policy should be rising in tandem. She noted that FOMC members project that the equilibrium real Fed Funds rate will rise to 1.75% in the longer term, or 5-10 years from now. She concluded that,

Provided that inflation shows clear signs over time of moving up toward 2 percent in the context of continuing progress toward maximum employment, I therefore expect that a further tightening in monetary policy after the first increase in the federal funds rate will be warranted. Should incoming data, however, fail to support this forecast, then the actual path of policy will need to be adjusted appropriately.

Does Anybody Really Know?

My review of this debate convinces me of one thing. Central bankers do not have strong empirical foundations for determining the appropriate level of policy rate. Current low policy rates can be rationalized by assuming that the real equilibrium policy rate has fallen sharply and by assuming that our economies are still some distance below full employment. Some economists don't buy these assumptions. But neither side in the debate can prove that the other side is wrong.

As long as Yellen and Poloz remain at the helm of their respective central banks, low policy rates and very gradual rate normalization seem likely.

Does anybody really know what the equilibrium real policy rate is? Does anybody really care? (If you are exhausted after reading this, for some musical relaxation, see here .)

Atrocious?: Canada's economy in 1Q15

"The first quarter of 2015 will look atrocious, because the oil shock is a big deal for us".

That's what Bank of Canada Governor Stephen Poloz told the Financial Times in an interview on March 30. Since then, quite predictably, Canadian economists and financial journalists have been debating the meaning of the word atrocious. 

One observer cited Merriam Webster’s online dictionary definition of the word atrocious as “of very poor quality …  appalling … horrifying”. Most economists who have weighed in on the debate have argued that the 1Q15 economic data seen so far does not meet the definition. In spite of that, these same economists, after being shocked by the BoC's January rate cut, have been busy revising down their growth and inflation forecasts. 

So How Bad Is It?

Most of the sound bites in this debate have been reactions to individual economic releases. For example, real GDP declined by just 0.1% in January and economists judged that to be weak but not atrocious. The economy added 29,000 jobs in March and, while the jobs were all part-time, that didn't look atrocious. But these data points give a very incomplete picture of how the economy performed in 1Q15. A preliminary estimate of real GDP for the quarter won't be published by Statistics Canada until May 29, so we must judge the quarter so far by a wide range of monthly economic indicators, the same indicators that the Bank of Canada will utilize to update its economic projections to be released in the Monetary Policy Report on April 15.

The first place to look is at the source of the shock: the decline in the price of crude oil.

OK, that's atrocious! The price of energy commodities produced in Canada fell 53% from June 2014 to March 2015 with the bulk of the decline occurring in the December to March period. So what is the direct impact? First, lets look at Canadian energy exports, which account for about half of Canada's total exports.

In the three months to February, the value of energy exports fell 22% (or 63% at annual rates). That's atrocious! The plunge in energy exports pulled down the value of total exports by 1.6% (or 6.2% ar) over the same period. That's weak, but not atrocious. In volume (or real) terms, total exports are on track to be down 1.2% ar in 1Q15, after falling 3.0% in 4Q14. Soft, but not atrocious. While the value of energy exports has collapsed, the impact on total exports has been negative but not disastrous.

The next place to look is business investment. Governor Poloz told the FT that capital expenditures could fall by as much as 10% as a result of energy companies cutting back on investment. The energy sector has been the leader in rising business nonresidential investment in Canada in recent years. While there is little direct evidence on business investment in 1Q15, the Bank of Canada's Business Outlook Survey shows a weakening in investment plans.

The balance of opinion on machinery and equipment investment spending has fallen sharply in response to the plunge in the price of crude oil. The balance, at +4 in 1Q15, was the weakest since the recession of 2008-09. The Business Outlook Survey noted,

Weakness in investment intentions was concentrated in the goods sector and among firms that reported being adversely affected by lower oil prices ... Although firms outside the energy sector report that the outlook for U.S. growth and a weaker Canadian dollar are generally favourable for them, the positive impact on their investment intentions is taking time to materialize.

Machinery and equipment investment is only part of the business investment picture. Non-residential construction is another important component. Here once again, we have little direct evidence, but we can look at building permits. The value of permits for non-residential construction in the first two months of 2015 were down 22% (or -63% annual rate) from the fourth quarter level. Now that's atrocious!

Let's turn to residential construction sector. Many observers have noted that while housing activity remains strong in central Canada, the impact of lower oil prices is weighing on the the residential real estate market in Alberta and other energy producing regions. Housing prices are still rising in Toronto and Vancouver, but are falling in Calgary and Edmonton. But what about residential building permits and housing starts. The value of residential permits in the first two months of 2015 were down 7% (or -25% annual rate) from the fourth quarter level. That's verging on atrocious. And housing starts were also down sharply. Single-family housing starts fell 10% (or -35% ar) while multiple unit dwelling starts fell a more moderate 2.4% (or 9%ar).

What about consumer spending, which was supposed to benefit from lower gasoline prices. Real retail sales fell 1.2% in both December and January, which puts sales volumes on track for a 7% decline at annual rates for 1Q15. That's very weak! We could be surprised by a retail sales rebound in February-March, but I doubt it. More likely sales fell further in February and posted a modest rebound in March.

Another sector that should benefit from lower oil prices is manufacturing. Real manufacturing sales fell 3.2% ar in 4Q14 and were down 1.0% in January. But the interesting manufacturing data that we have is the Markit/RBC Manufacturing Purchasing Manager's Index (PMI), shown in the chart below:



The PMI, a diffusion index, fell below 50 in February and March, posting its lowest readings since its inception in late 2010. Although it does not have a long history, it correlates relatively well with the rolling 3-month annualized growth rate of Canada's real GDP, shown by the blue line in the chart. It suggests that further weakening of real GDP growth in 1Q15, to somewhere in the -1% to +1% range.

But what about employment and those 29,000 jobs in March? As mentioned, the economy actually lost 28,000 full time jobs and added 57,000 part-time jobs. Total hours worked, a better measure of labour input barely grew at all in 1Q15, rising just 0.3% ar, in line with very weak growth or even a modest decline in real GDP.

Was the Atrocious Comment Justified?

On balance, I would say yes, the plunge in crude oil prices did have an atrocious impact on 1Q15 growth. The data on 1Q15 that we currently have in hand is mixed between soft, very weak, and atrocious. In my opinion, it is weak enough to justify a further downgrade in the Bank of Canada's projection for real GDP growth in the April 15 Monetary Policy Report. In this sense, the comment was justified, albeit somewhat bold.

Is it weak enough to justify another 25 basis point cut in the policy rate to 0.50%. In my opinion, yes it is. Some observers believe that 2Q15 will post a meaningful rebound in growth. With the price of oil still barely above $50/bbl, I don't see why a strong rebound should be expected.

Poloz has taken a lot of criticism for surprising economists and markets with the rate cut in January. However, the negative impact of the oil price plunge on the Canadian economy is being borne out by the data. If the BoC cuts the policy rate again on April 15, his critics won't be able to say that he didn't warn them.

The Big No and The Big Mo

In a March 27 speech, Fed Chair Janet Yellen focused on what I call "The Big No" -- policy rate normalization. The Fed has spelled out what it means by the Big No as follows:

Specifically, monetary policy normalization refers to steps to raise the federal funds rate and other short-term interest rates to more normal levels and to reduce the size of the Federal Reserve’s securities holdings and to return them mostly to Treasury securities, so as to promote the Federal Reserve’s statutory mandate of maximum employment and price stability.

In short, this is the process of unwinding the Fed's emergency policies of ZIRP (zero interest rate policy) and QE (quantitative easing).

The premise of this post is that the Big No will bring to an end what I call "The Big Mo" -- the momentum trade that has seen the steady rise in the valuations of risk assets that has accompanied the use of unconventional monetary policies.

Yellen and the Big No

Fed Chair Janet Yellen's speech on March 27, "Normalizing Monetary Policy: Prospects and Perspectives", laid out the FOMC's views on policy rate normalization following the March Fed meeting. The Summary of Economic Projection (SEP) provided by FOMC members suggested that as the economy continues to improve and move toward meeting the Fed's dual mandate of maximum employment and price stability, the Fed Funds rate will move up as shown in the chart below.

The blue line in the chart shows the median expected path of the Fed Funds rate derived from the projections of the individual FOMC members (the so-called dot plot). The red line shows the minimum projection and the green line, the maximum projection. In outlining the Big No, Ms. Yellen made the following points:

• the FOMC's decisions will be data dependent; should incoming data fail to support [the SEP] forecast, then the actual path of policy will need to be adjusted appropriately;
• the level of the federal funds rate will be normalized only gradually;
• the FOMC does not intend to embark on any predetermined course of tightening following an initial decision to raise the funds rate target range -- one that, for example, would involve similarly sized rate increases at every meeting or on some other schedule;
• the FOMC recognizes that many market participants assess the outlook quite differently. The Survey of Primary Dealers in late January thought there was a 20 percent probability that, after liftoff, the funds rate would fall back to zero sometime at or before late 2017.
• there are risks to moving either too slowly or too quickly.

The median path projects that the Fed Funds rate will follow a smooth path, rising to 3.25% by the end of 2017. The most optimistic FOMC member projected a rate of 4% by the end of 2017, while the least optimistic projected a rate of 2%. Any one of these scenarios would be a sharp break after six years of the policy rate being pinned down at close to zero.

Can the economy and markets handle a move in the funds rate along the median path? Some are not so sure. Ray Dalio of Bridgewater Associates warned against a 1937 style policy mistake and cautioned the Fed this way:

We don’t know — nor does the Fed know — exactly how much tightening will knock over the apple cart. What we do hope the Fed knows, which we don’t know, is how exactly it will fix things if it knocks it over. We hope that they know that before they make a move that could knock over the apple cart.

Christine Lagarde of the IMF warned of emerging markets instability as the Fed normalizes monetary policy. The staff of the BIS has warned that given the massive rise in US dollar credit since the Fed launched it unconventional monetary policy, US rate hikes pose a major threat to global financial stability (see here and here).  

The Big Mo

 
Since the Fed began the pursuit of unconventional monetary policy, asset valuations have risen steadily and volatility in financial markets has been suppressed by the low policy rate and regular injections of central bank liquidity. Using ETF total returns, the chart below shows the steady rise in valuations of US equities (SPY, the green line), government bonds (TLH, the yellow line) and high yield credit (HYG, the blue line).

Total Returns (including all dividends)

Since the Fed went to ZIRP in December 2008, SPY has returned 163% (16.6% per annum), HYG has returned 123% (13.6% p.a.) and TLH has returned 42% (5.7% p.a). During this period, equity valuations, measured by Shiller's Cyclically Adjusted Price Earnings (CAPE) ratio have risen to highs exceeded only in the periods before the 1929 and 2000 market crashes. Bond yields have fallen to record lows, implying bond prices at record highs. And high yield credit spreads have fallen back to pre-GFC lows.

As long as markets could anticipate that the Fed would respond to any economic weakness by further easing of monetary policy, asset values continued to rise. Market participants have been paid to stick with the momentum trade -- the Big Mo: long equities, long duration, and long credit.

When the Big No begins, the Big Mo ends

In May 2013, former Fed Chair Bernanke spooked markets by indicating that the Fed would begin to taper its quantitative easing program. Equities, bonds and high yield credit markets all experienced a correction and a rise in volatility -- a "taper tantrum" -- that lasted a few weeks for equities and credit and a few months for bonds. In August 2014, Fed Chair Yellen gave a speech at Jackson Hole that laid the groundwork for the Fed to begin the discussion of policy rate normalization. Once again, equities, bonds and high yield credit markets experienced corrections lasting three to six weeks.

With the March 2015 FOMC meeting and Yellen's March 27 speech, the Fed indicated that it expects to begin policy rate normalization later this year, possibly as early as June, and laid out a range of scenarios for the expected policy tightening path. In the wake of this decision, the momentum trade -- the Big Mo -- has shown early signs of breaking down again. 

So here is the new counter-intuitive conundrum for investors as the Fed moves toward the Big No: sustained solid improvement in the US economy is likely to be bad for all three asset classes that benefitted in the Big Mo trade: equities, bonds and high yield credit.

For the Big Mo trade to continue to perform, growth will need to stay mediocre and inflation will need to remain below target. This type of economic outcome will push back policy rate normalization and keep highly accommodative monetary policy in place.

That's why the disappointing US employment report for March on Good Friday saw stocks and high yield credit rally when markets reopened on Monday. The soft employment report pushed back the market's assessment of the timing of the beginning of the Big No to September from June.    

Global ETF Portfolios: 1Q15 Review and Outlook

Global ETF portfolios for Canadian investors continued their stellar performance in the first quarter of 2015. Most of the strong performance was attributable to a further 8.4% depreciation of the Canadian dollar relative to the USD that provided a profitable tailwind for Canadian investors in USD denominated global ETFs.

Global economic developments were, once again, disappointing:

• Global growth and global inflation were both significantly weaker than expected in 1Q15.   
• Nine of the eleven large economies that I track have had their 2015 growth forecasts revised down since the beginning of the year. The exceptions are the Eurozone, where the growth forecast has barely edged up, and India, which has been a legitimate positive surprise. Russia and Brazil are contracting. China is slowing, probably by more than the official statistics.
• Nine of the eleven large economies that I track have had their 2015 inflation forecasts revised down. The exceptions are Brazil and Russia, where large exchange rate depreciations are pushing inflation higher.
• Led by crude oil, commodity prices continued to decline in 1Q15, putting further downward pressure on the currencies of commodity exporting countries, including Canada.
• Global central bank policies diverged. The US Fed continued to prepare markets for an increase in the policy rate in 2015. The BoJ pursued and the ECB initiated aggressive quantitative easing. Other central banks, including the BoC and the PBoC, responded to weakening growth, plunging oil prices and falling inflation by cutting their policy rates. Russia and Brazil were forced to hike policy rates to support their currencies. 
• The USD appreciated against virtually all global currencies.
• Bond yields fell virtually everywhere, again with the exception of the distressed economies.

From my perspective, a key development for markets was that, despite much weaker than expected US economic growth and inflation in 1Q15, the Fed continued to stress the need for "policy normalization". At the March FOMC meeting, the Fed dropped the use of the word "patience" form its policy guidance and Fed Chair Janet Yellen indicated that this meant that the policy rate would likely rise later in 2015. Importantly, the Fed signalled that the normalization of rates would be gradual and dependent on incoming economic data. This note of caution took some of the steam out of the US dollar appreciation, but only pushed back analysts expectations of the timing of the first rate hike by a few months at most.

For its part, the Bank of Canada surprised most observers by cutting its policy rate by 25 basis points to 0.75% in January. The Canadian dollar (CAD) depreciation versus the USD accelerated following the BoC move. Many observers criticized the BoC for not signalling the rate cut more clearly, but as the quarter ended, it appeared that the BoC's concerns, that the plunge in crude oil prices would produce a sharp negative shock to both growth and inflation, were well founded.

Global Market ETFs: Performance for 1Q15

In 1Q15, with the USD appreciating 9.2% against the CAD, the best global ETF returns for Canadian investors were in Japanese and Eurozone equity ETFs. Despite the weakening of their currencies, the two equity markets where central banks pursued the most aggressive monetary stimulus posted the strongest global returns. The worst returns were in commodities. The chart below shows 1Q15 returns, including reinvested dividends, for the ETFs tracked in this blog, in both local currency terms (i.e. USD terms for the global ETFs) and in CAD terms.

In local currency terms, 14 of the 19 ETFs posted positive returns, while 5 ETFs posted losses. In CAD terms, 18 of 19 ETFs posted gains, while just 1 posted a loss.

The best gains were in the Japanese equity ETF (EWJ) which returned a stunning 21.7% in CAD. The Eurozone equity ETF (FEZ) was second best, returning 15.0% in CAD. Other strong gainers included US Small Cap equities (IWM), which returned 13.5% in CAD; USD-denominated Emerging Market bonds (EMB) 12.3%; US Long Bonds (TLH) 12.3%; US Investment Grade bonds (LQD) 11.9%; Emerging Market equities (EEM) 11.5%; US High Yield bonds (HYG) 11.3%; US Inflation-linked bonds (TIP) 10.7%; and US Large Cap equities (SPY) 10.1%.

Canadian assets underperformed global ETFs in 1Q15. The Long Bond ETF (XLB) returned 7.2%; the Real Return bond (XRB) 6.6%; the Corporate bond (XCB) 3.2%; and Canadian equities (XIU) 2.7%. 

The worst performer, by far, was the commodity ETF (GSG), which returned -1.4% in CAD. The Gold ETF (GLD) fared better with a virtually zero return in USD but a 9.2% return in CAD terms.

Global ETF Portfolio Performance for 1Q15

In 1Q15, 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 8.1% in CAD when USD exposure was left unhedged, but just 3.4% 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 6.3% if unhedged, but just 1.7% if USD hedged.

Risk balanced portfolios outperformed in 1Q15, continuing the trend established in 2014. A Levered Global Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a robust 12.1% in CAD terms if USD-unhedged, but had a less stellar gain of 2.6% 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 8.3% if USD-unhedged, but just 1.5% if USD-hedged.

Recent Performance in Perspective

The robust performance, in Canadian dollar terms, of the unhedged global ETF portfolios has been driven largely by the strength of the USD versus CAD.

The twin causes of the CAD weakness have been the plunge in commodity prices, led by crude oil which is Canada's largest export, and the divergence and Fed and BoC policy. It is an interesting question as to whether these trends will continue.

Crude oil inventories are at record levels and oil production continues to run ahead of demand. Many analysts expect crude oil prices to fall further in 2Q15.

Fed and BoC policy divergence has accelerated the weakening of CAD. In both countries, 1Q15 growth and inflation have fallen short of expectations. While the Fed has so far remained steadfast that policy rate normalization will begin later this year, the BoC has responded to a huge negative terms of trade shock (appropriately in my view) by cutting its policy rate. The US economy appears better positioned than Canada for a 2Q15 rebound, but the soft US employment report for March suggests caution. If growth disappoints in both countries as 2Q unfolds, however, it is likely that the Fed response will just be to delay tightening, while the BoC response will be to cut rates again.

In this environment, maintaining unhedged exposure to global ETFs remains my preferred portfolio stance.   

While the more conservative 45/25/30 portfolio (which I have favoured) under performed the more aggressive ETF portfolios, we can hardly be dissatisfied with a year-to-date return of 6.3%. As we enter 2Q15 in a continuing uncertain environment, characterized by significant global divergences in growth and central bank policies, and with rich valuations for both US equities and bonds, remaining well diversified with an ample cash position continues to be a prudent strategy.

Chronic Dissonance: Boom or Bust?

From Wikipedia, the free encyclopedia:

In psychology, cognitive dissonance is the mental stress or discomfort experienced by an individual who holds two or more contradictory beliefs, ideas, or values at the same time, or is confronted by new information that conflicts with existing beliefs, ideas, or values. 

Leon Festinger's theory of cognitive dissonance focuses on how humans strive for internal consistency. When inconsistency (dissonance) is experienced, individuals tend to become psychologically uncomfortable and they are motivated to attempt to reduce this dissonance, as well as actively avoiding situations and information which are likely to increase it.

I admit to experiencing chronic dissonance these days. My views on global markets are influenced by two contradictory beliefs. I am trying not to actively avoid information which is likely to increase the dissonance and my discomfort. The dissonance makes investment decisions difficult because one set of beliefs tells me to add to my risky investments in equities and high yield credit, while the other tells me to reduce risk.

I read a lot of macro research and strategy produced by some of the brightest people in the investment industry. I like to follow analysts who are challenging and engaging. I enjoy differing points of view, which are always out there and also what makes a market.

What has struck me recently, however, is how divergent the views of some of my favourite analysts have become. The divergence in their views and investment recommendations, I believe, stems from their differing analytical frameworks.

Two Frameworks 

One framework emphasizes high frequency data watching combined with momentum investing (or, for short, the HFMI approach). This approach closely follows developments in macroeconomic data to track the business cycle, inflation trends and central bank policy guidance to assess the likely direction of interest rates, exchange rates, equity prices, commodity prices and credit spreads.

Leading practitioners of this framework are presently focused on the recent strength of the US economy (especially the US labor market), the increasing likelihood of Fed tightening this summer, and the stimulative economic effects of both the oil price decline and easing by non-US central banks. Strategists who employ this framework tend to be quite bullish, favouring the "growth trade", characterized by overweight positions in equities, select commodities and credit and underweight positions in government bonds, especially long duration bonds.

Another framework emphasizes balance sheet analysis combined with capital preservation (or the BSCP approach). This approach follows less-watched data on capital flows, national and sectoral balance sheets, debt levels, credit spreads and market liquidity. It interprets high-frequency economic data against the backdrop of balance sheets and valuation levels. 

Strategists who employ this framework tend to be much more cautious about the economic and investment outlook. They tend to emphasize the continued rise in global debt ratios, the overbuilt or bubble conditions that exist in some key economies and sectors, and the persistence of deflationary pressures. They worry about the impact of rapid decline in crude oil prices and the rapid rise in the value of the US dollar and their potential impact on financial stability.

When I worked for a large institutional pension fund, I had the privilege of meeting Ray Dalio and several other fine analysts and
strategists at Bridgewater Associates. Dalio has posted a 30-minute video on YouTube on "How the Economic Machine Works" that every investor should take the time to watch. Within the first minute of the presentation, Dalio outlines the three main drivers of the the economy:

• Productivity growth;
• the short-term debt cycle (or the business cycle); and
• the long term debt cycle.

The interaction of these three drivers determines the path of economic growth and inflation. Productivity growth, the key element of longer-term economic prosperity, does not draw much attention from investors who tend to focus on shorter-term factors that influence the ups and downs of the economy. 

The short-term debt cycle, or the business cycle, is the focus of practitioners of the first framework that I mentioned above, the HFMI approach. The long-term debt cycle is the focus of practitioners of the second framework, the BSCP approach.

The advantage of the HFMI approach is that, most of the time, short-term business cycles determine the ups and downs of the economy and markets. The main disadvantage of the HFMI approach is that it tends to miss (and be surprised by) turning points in long-term debt cycles, as occurred in 2008-09 when the US housing bubble burst, triggering rapid deleveraging, a disastrous tightening of liquidity and a meltdown of a wide range of asset prices.

The advantage of the BSCP approach is that it actively tracks the long-term debt cycle and, if astute, can prepare for the large downturns in economic activity and drawdowns in investment returns that occur when bubbles burst. The main disadvantage of the BSCP approach is that the triggers for the bursting of bubbles are quite unpredictable. It can be true that a dangerous bubble has developed, but without a trigger the bubble can persist for a long time. The over-cautious BSCP investor can miss out on much of the benefit of persistent market rallies in bubble periods.

The current situation

A pickup in US growth in 2H14, a dramatic halving in the price of crude oil as supply grew faster than demand, and renewed monetary easing by the BoJ and the ECB have made practitioners of the HFMI approach more optimistic about global growth. Some HFMI strategists have gone all in for the growth trade.

But, here is the current concern from the BSCP approach. In the period since the Great Financial Crisis (GFC), government policies have aimed to support growth and fight deflationary tendencies. These policy measures have been taken to extraordinary lengths. The US and China supplied very large scale fiscal stimulus in the depths of the crisis. Central banks in the large DM economies took their policy interest rates down to close to zero and have held them there for six years. The Fed, the BoE, the BoJ and the ECB have all undertaken quantitative easing, dramatically expanding the size of their balance sheets. In some countries, including the UK, Canada, Australia and Hong Kong, low interest rates and easy credit availability led to large increases in housing prices and household debt ratios.

Since the GFC, China's central bank, the PBoC, has encouraged the fastest credit growth in memory. For a while, this supported high levels of economic growth in China and other emerging market economies. In the process, China became the world's largest economy (according to new measures of purchasing power parity from the IMF). However, it became apparent that a byproduct of the Chinese credit binge was that housing, infrastructure and industrial capacity all became seriously overbuilt. However, the Chinese economy is now slowing more than expected (and probably much more than indicated by official GDP figures). Other large EM economies, some with large trade ties to China such as Brazil, and others for geopolitical reasons, such as Russia and Turkey, have also slowed sharply. Overhanging this situation is China's housing bubble, the magnitude of which is quite comparable to that of the US housing bubble prior to the GFC. 

What is unknown is whether the Chinese authorities will be able to let the air out of the bubble without the crash witnessed in the US. The Chinese government began to adopt more restrictive housing policies some time ago. Now, with the the housing sector contracting and the economy slowing sharply, the PBoC has begun to ease, cutting the policy rate and lowering banks' required reserve ratio.

With the PBoC easing and the US Fed expected to begin tightening soon, the Chinese yuan's loose peg to the US dollar has come under pressure. With the USD surging in recent months and the CNY still maintaining a loose peg, the Chinese currency has appreciated dramatically against the Japanese Yen and currencies of other Asian competitors. The PBoC has recently permitted the trading band of the CNY to weaken against the dollar. A devaluation of CNY could become necessary (or unavoidable) if the Chinese economy cools too fast. That would lower the prices of a wide array of consumer goods imported from China by the US and other DM economies, adding to global deflationary pressures.

Countries like Canada and Australia have high stakes in how China's overcapacity problem is managed. Already these two commodity-exporting economies have been hit with sharp deteriorations in their terms of trade, a big negative shock to their gross domestic incomes and corporate profits, which has led their central banks to cut their policy rates. The CAD and AUD have weakened sharply. Housing markets are cooling in resource producing regions of these countries and this is likely to spread over time as commodity prices seem likely to remain depressed for some time.

Could the Fed's expected rate hike be unfortunately timed to coincide with a deepening slowdown in China and a new global deflationary shock? This is the dissonance that I am experiencing. How about you? Is it boom or is it bust? Is it go all in for the growth trade or should we focus on capital preservation after US bond and equity prices have reached all-time highs? As a Canadian investor, I remain in a cautious portfolio, with 45% equities, 25% bonds and 30% cash with a high exposure to US dollar denominated assets. When the dissonance diminishes, I should be able to deploy the cash at more attractive valuations for equities, bonds or both. 







        

Why Poloz Took Out Insurance

To read the Canadian financial press, Bank of Canada Governor Steven Poloz "shocked" markets when he cut the policy rate on January 21. Some economists, who were still forecasting that the BoC's next move would be a rate hike in late 2015, covered their tracks by highlighting that Poloz noted that the rate cut was insurance against downside risk to the economy. These analysts seemed to imply that Poloz was just being cautious in response to an "uncertain" impact of the sharp drop in the price of crude oil.

In fact, the Bank of Canada had a very good idea of what the economic impact of the drop in the crude oil price would be. The BoC's macroeconomic projection model has the acronym ToTEM, short for Terms of Trade Economic Model. The model recognizes that as a mid-sized, high-income, technologically-advanced, commodity-exporting economy, Canada's economic performance is closely tied to movements in the prices of the commodities that it exports.

In the final two pages of its January Monetary Policy Report, the BoC clearly laid out its estimates of the impact that the drop in crude oil prices would have on the economy. Using the ToTEM projection model, the BoC estimated that, assuming no change in the policy rate, the drop in the crude oil price from $110/bbl to an average of $60/bbl in 2015-16 would cut real GDP by 1.4%, real consumption by 1.3%, and real investment spending by 5.2%. 

Forecasters can argue that they they were "shocked" because they don't have sophisticated projection models that take full account of the impact of changes in Canada's commodity prices and terms of trade. But, in my opinion, this is no excuse. If these forecasters had carefully examined how sharp declines in Canada's commodity price index had affected the economy in the past, they should have known that a cut in the policy rate was much more appropriate and much more likely than a rate hike.

The 2014-15 Commodity Price Shock

The chart below shows the main indicators of Canada's current massive negative commodity price shock. While energy prices, which have a weight of just under 50% in the commodity price index, are the current focus of attention, it is worth noting that Canada's non-energy commodity prices have fallen about 16% since hitting their all-time high in April 2011. The horizontal scale shows the number of months before and after crude oil and gasoline prices hit their low point. The commodity price index was down almost 40% from a year earlier in January 2015. Gasoline prices, reflecting the sharp drop in crude oil prices, were down almost 30% from a year ago, implying a drop of about 15% in the CPI for energy products. Industrial production (IP) was only available through November 2014, when it was up 2.1% from a year earlier.

The debate in early January, before the BoC cut the policy rate, was about what impact the sharp drop in the price of crude oil would have on Canadian inflation and growth. Most forecasters had not fully factored in impact the the drop in the price of gasoline would have on the total inflation rate. And almost none of the forecasters had factored in any significant impact on growth.

What Happened in Previous Commodity Price Shocks?

The current period is not the first time that Canada's commodity price index has collapsed. There have been three previous occurrences in the past 30 years. What happened to growth, inflation and the Canadian dollar in those periods? The chart below shows how the indicators performed on average during three similar shocks in the past. As in the chart above, the horizontal scale shows the number of months before and after crude oil, gasoline prices, and the CPI for energy hit their low point.

The three previous commodity price shocks occurred in 1986, 1998 and 2008-09. The chart shows that on average, the commodity price index fell about 25% y/y at the low point of these shocks. The CPI energy fell 15% y/y on average at its' low point, mainly reflecting lower crude oil and gasoline prices. The Canadian dollar depreciated about 12% from its peak on average. The key is what happened to industrial production: on average it fell 5% y/y, with the low point occurring around the same time or shortly after crude oil and gasoline prices hit their lows.

Only in 2008-09 did the commodity price collapse coincide with a recession, but in all three previous episodes, industrial production, the key indicator of the business cycle, slowed sharply when commodity prices fell. (Separate charts for each commodity price shock are shown at the end of this post.)

In all three previous commodity price collapses, the Bank of Canada cut its policy rate. Why was it a "shock" to forecasters that the BoC cut again in January? Why did Poloz take out insurance? Because as history tells us, and as the the ToTEM model projected, there was a very high risk of not only a sharp drop in inflation, but also a sharp drop in growth.

Did the 25 basis point policy rate cut buy enough insurance? Not likely. The BoC's January projection assumed that the price of crude oil would average $60/bbl over 2015-16. As Poloz noted in January, "Obviously, [the downside] risks would be even more material if oil were to average $50 a barrel". A mere 25 basis point rate cut is unlikely to mitigate significantly the impact of one of the biggest commodity price collapses of the past three decades.

For those who want to study each of the three previous commodity price collapses in more detail, individual charts for 1986, 1998 and 2009 are shown below.