January 2016, which began as the worst start to a year ever for US equities, saw a rebound in the last two weeks of the month to become just the worst January for equities since 2009. Of course, the loss of momentum in US stocks had been developing since the S&P500 hit an all-time high in May 2015.
Over the past year, I posted twice on the theme of momentum. In March, in a post titled Chronic Dissonance: Boom or Bust, I compared two global macro investment frameworks that were sending quite different signals. The first was the High Frequency Momentum Investing (HFMI) approach, which 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. The second was the Balance Sheet Capital Preservation (BSCP) approach, which follows less-watched data on capital flows, national and sectoral balance sheets, debt levels, credit spreads and market liquidity, and interprets high-frequency economic data against the backdrop of balance sheets and valuation levels.
I remarked at that time that the investment views of some of my favourite practitioners of these two frameworks were diverging and offering very different investment advice. The HFMI approach was bullish on global growth prospects and its strategists were recommending going all in on the "growth trade", characterized by overweight positions in equities, select commodities and credit and underweight positions in government bonds, especially long duration bonds. The BSCP approach was much more bearish, emphasizing 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. Given my views that valuations across many asset classes were stretched, I sided with the BSCP approach, favouring a more defensive portfolio, holding 45% equities, 25% bonds and 30% cash with a high exposure to US dollar denominated assets.
In April, I returned to the momentum theme with a post titled The Big No and the Big Mo, in which I argued that the US Fed's decision to move toward what I called "The Big No", monetary policy normalization, would bring to an end "The Big Mo", the momentum trade that had seen the steady rise in the valuations of risk assets that had accompanied the use of unconventional monetary policies.
Looking back, I think that both of these posts stood up pretty well as the year unfolded. After rallying early in the year, US high-yield credit peaked at the end of February. US equities peaked in mid-May. From mid-May until the end of January, the US equity ETF (SPY) returned -9.1% in USD terms, the Canadian equity ETF (EWC) returned -26.2%, the US high yield credit ETF (HYG) returned -9.4%, and the US 10-20yr Treasury bond ETF (TLH) returned +5.0%. It seems that the concerns of strategists following the BSCP approach were borne out. A momentum shift occurred.
Antonacci's Dual Momentum Investing
As these events were unfolding, I was reading Gary Antonacci's new book, Dual Momentum Investing. It is easily the best investment book I read last year, and one of the best I have ever read. I am not going to review the book, but I will say that even if Antonacci's strategy doesn't suit your investment style, you will learn a great deal about asset return momentum, portfolio theory and asset allocation from his book.
Since some of the best strategists I have followed over the years have employed some form of momentum investing, I was intrigued to see what evidence could be mounted to support the approach. On this front, Antonacci writes in the Preface to his book (p. xiv),
Momentum, or persistence in performance, has been one of the most heavily researched finance topics over the past 20 years. Academic research has shown momentum to be a valid strategy from the early 1800s up to the present, and nearly across all asset classes. After many years of such intense scrutiny, the academic community now accepts momentum as the "premier anomaly" for achieving consistently high risk-adjusted returns.
In my opinion, the best part of the book is Chapter 8, where Antonacci provides a simple, practical method of constructing an investment approach based on Dual Momentum, which can be implemented using the same kind of low-cost global ETFs that I use for the portfolios that are tracked in this blog.
Antonacci distinguishes between "absolute momentum" and "relative momentum". Absolute momentum is an absolute return concept, an asset's excess return (i.e., its return less the riskless t-bill return) over a given look back period. If an asset's return has been going up more than the T-bill return, it has positive momentum; if less, it has negative momentum. Relative momentum is a relative return concept, which compares an asset's excess returns to those of its peers over a given look back period. For example, one could compare the returns of the S&P500 with returns on other equity indexes, such as the Euro Stoxx, or the Japanese Topix, or the Canadian S&PTSX300, or the FTSE Emerging Markets index to judge relative equity momentum.
The Dual Momentum approach, suggested by Antonacci is a rules-based approach that utilizes a combination relative and absolute momentum. It is well described by Ben Carlson on his Wealth of Common Sense blog as requiring only three ETFs,
The relative momentum rule requires a comparison of the past 12 month returns for U.S. versus international stocks. The absolute momentum rule compares the higher trending of these two stock markets to the past 12 month returns for t-bills. If the S&P 500 [or SPY] has a higher return than both international stocks [ACWX] and cash [i.e. t-bills], you hold the S&P. If international stocks have a higher return than the S&P and cash, you hold international stocks. If cash has a higher return than stocks, you hold the bond fund [TLH].
The chart below shows total returns, as growth of $100,000 in USD terms, for SPY (green line), ACWX (blue line) and TLH (yellow line) from March 31, 2008 through Jan 29, 2016.
Antonacci backtested the Dual Momentum approach and found that over the 40-year period from 1974 to 2013, the approach "has an average annual return of 17.43% with a 12.64% standard deviation, a 0.87 Sharpe ratio, and a maximum drawdown of 22.7%. This almost doubling of the [MSCI All-Country World Index] comes with a reduction of volatility of 2%".
So What's Happened to Momentum Lately?
The chart below shows the 12-month total returns for SPY (green), ACWX (blue), and TLH (yellow) through the end of January 2016. [Total returns include all dividend and/or interest payments].
The month-end 12-month return on SPY has fallen below zero, as has the return on ACWX. By my reckoning, this implies that the Dual Momentum approach would shift out of SPY into TLH, the bond ETF, at the opening of markets on February 1, 2016.
One concern some investors may have about the Dual Momentum approach described above might be that that it is a concentrated portfolio holding only one ETF at a time. Another concern may be that using a 12-month return, the approach might not perform well in the event of a sudden meltdown in financial markets. Nevertheless, Antonacci's Dual Momentum Approach has an enviable back-tested track record and opens up a wealth of possible ideas for structuring global ETF portfolios.
How I Look at Momentum
Momentum has shifted. After several years of stronger 12-month total return momentum for global equities relative to other asset classes (including bonds, credit, inflation-linked bonds (ILBs) and commodities), in December global bonds return momentum overtook that of global equities in CAD terms, and in January 2016 global equities sank to the lowest momentum asset class. Even the best commodity ETF that I track, GLD, the gold ETF had stronger 12-month momentum than SPY, the best equity ETF.
The chart below splices together the 12-month returns on the top performing equity ETFs, top-performing bond ETFs (including credit), top performing ILB ETFs, and top performing commodity ETFs that we track. In the case of global equities, for example, over the 36 months ending December 2015, momentum leadership was held by the US large-cap equity ETF (SPY) for 11 months, the US small-cap ETF (IWM) for 9 months, the Japanese equity ETF (EWJ) for 8 months, the Eurozone equity ETF (FEZ) for 6 months, and the Canadian equity ETF (XIU) for 1 month. Since this blog is focussed on Canadian investors in global ETFs, the returns in the chart are shown in Canadian dollar terms.
The chart shows that, in CAD terms, 12-month momentum in global equities has exceeded that of the other asset classes in 33 out of the past 37 months. The exceptions were January 2015, October 2015, December 2015 and January 2016. On each of these occasions, the best global bond ETF return exceeded the best global equity ETF return. And on each of these occasions, the best global bond ETF was the 10-20yr US Treasury bond ETF (TLH).
I have examined an investment approach using this data and a rule that says hold only the ETF with the best 12-month return momentum (Mom12) determined at the end of each month. Also, to alleviate concerns about sudden corrections and concentration in a single ETF, I have also looked at employing 6-month momentum (Mom06) and choosing the two top performing ETFs across all of the asset classes. The chart below shows returns that would have been generated by these two approaches, as well as returns from the more diversified portfolios that we normally track, from the beginning of 2013.
Over the past three years, the two portfolios based on simple momentum rules would have outperformed all of the other more diversified portfolios that I normally track. Over the entire period, both the 12-month momentum portfolio (Mom12) and the 6-month momentum portfolio (Mom06) have generated returns of over 13.5% annualized in CAD terms, about 2% per annum above the best of the diversified portfolios and about 9% per annum better than a simple all-Canadian 60/40 ETF portfolio. As might be expected, the momentum portfolios have had higher volatility than the other more diversified portfolios, but the higher volatility has generated higher returns over the recent period.
It is also worth noting that, at the end of December, the Mom12 portfolio fortuitously shifted out of equities (specifically EWJ, the Japanese equity ETF) into bonds (specifically TLH, the US 10-20yr Treasury Bond ETF) and thereby managed a monthly gain for January of 1.3% in CAD terms. The Mom06 portfolio wasn't so lucky; based on 6-month momentum it held 60% SPY and 40% TLH in January, which resulted in a -0.5% monthly loss. Nevertheless, both portfolios outperformed the Global 60/40 and the Canada 60/40 portfolios, which returned January losses of -2.6% and -1.2% respectively.
Conclusions
I believe that there is strong academic support for employing momentum in asset allocation in order to achieve higher risk adjusted returns. Gary Antonacci has provided an easy-to-execute momentum approach which has outstanding backtest results. I have identified two rather simple approaches using the global ETFs that I track. My results over the past three years discussed above, while not a robust backtest, are encouraging. In particular, I like the ability of the suggested momentum portfolios to take currency movements into account. During the recent period of Canadian dollar weakness, these momentum approaches would have had Canadian investors out of Canadian dollar denominated ETFs for virtually the entire period. When the Canadian dollar rallies back, it will be reflected in the relative total return momentum (in CAD terms) of the ETFs.
This does not mean that I will make a wholesale shift away from assessing global macro factors in my asset allocation decisions. Both the High Frequency Momentum Investing and the Balance Sheet Capital Preservation approaches that I have written about remain useful and insightful approaches to asset allocation. But I'm convinced that adding the momentum factor can improve investment results.
While investors are surely hoping that the worst is over for 2016, the momentum approach is still suggesting caution. Momentum rules point to overweighting (if not fully allocating) portfolios to bonds.
One year ago, I posted that "The Bank of Canada Should Open the Door to a Rate Cut". The following week, the BoC "shocked" economists and the business media by cutting its policy rate 25 basis points to 0.75%. I do not agree with those who say that it shocked the bond and currency market because those markets were already pricing about a 50% chance that a rate cut was coming in 1Q15.
A year ago, I focused on the likely impact the sharp drop in commodity prices (led by the collapse in crude oil prices) would have on the economy. I said,
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.
I noted a year ago that the Canadian dollar had weakened sharply, but that the depreciation had not kept pace with the weakening in the commodity terms of trade (which is simply equal to the Bank of Canada Commodity Price Index divided by the core CPI). The chart below updates this relationship.
The BoC's two rate cuts, in January and July 2015, combined with the US Fed's bias to hike rates, which it finally acted upon in December 2015, helped the depreciation of the Canadian dollar to keep pace with the continuing sharp decline in the commodity terms of trade.
I don't think many people recognize that Canada's commodity terms of trade in January 2016 are 28% weaker than they were at the lowest point of the Great Recession of 2008-09. And the prospect today for a quick rebound is not there as it was in early 2009, when the shale oil revolution had hardly begun, when China and other emerging economies were growing strongly and when the G20 was in the process of applying huge coordinated monetary and fiscal stimulus to the global economy. Indeed, most G20 leaders have recently been more focussed on cutting fossil fuel consumption than on providing stimulus for global growth.
In Canada, new governments at the federal level and in energy-rich Alberta, have promised to act on climate change, to increase infrastructure spending, and have already raised top personal income tax rates (while lowering "middle-class" tax rates). The combined effect of these measures over the next few years is unlikely to provide much, if any, real stimulus to growth. Indeed, continued uncertainty over resource royalties, payroll taxes for government run pension plans, and carbon taxes or cap and trade policies to address climate change seem likely to act as further meaningful drags on business investment and real GDP growth.
So the Bank of Canada should stay on course and cut the policy rate by another 25 basis points next week on January 20.
This is the recommendation that I made to the Bank of Canada in my role as a member of the C.D. Howe Monetary Policy Council (MPC). Some members of the were reluctant to call for another rate cut because they were concerned that doing so could trigger a further sharp depreciation of the Canadian dollar. Several suggested that the currency could overshoot its' "fair value" to the downside. One even suggested that the BoC could trigger a currency crisis.
In my opinion, these fears are way overblown. The depreciation of the Canadian dollar so far has just kept pace with the deterioration of Canada's commodity terms of trade. Ahead of the BoC decision next week, economists are about evenly split in their forecasts with an increasing number calling for a rate cut as commodity and equity markets weakened sharply over the first two weeks of January. The bond and currency markets have already priced in a better than 60% probability of another 25 basis point rate cut on January 20. If the BoC decides not to cut rates the Canadian dollar is likely to rally, preventing it from acting as the cushion to the terms of trade drop that it needs to be.
I would also point out that those arguing against a rate cut are mostly based in Ontario and Quebec. As we have seen in the past in Canada, regional views on appropriate monetary policy sometimes vary. Those in the non-resource regions of central Canada appear to want to have the benefits of lower crude oil and other commodity prices (in the form of lower consumer prices for gasoline and lower resource input costs for for manufacturing), but don't want to have to share the costs in the form of a weaker Canadian dollar that cushions the impact on resource industries but increases central Canadians' costs of imported food, Florida vacations and BMWs.
BoC Governor Poloz (and the Governing Council) has pursued the same approach to monetary policy in the face of a severe commodity price shock that his predecessors Mark Carney, David Dodge or Gordon Thiessen would have followed. If the current Governing Council is concerned about the Canadian dollar falling too much, it should cut 25 bps to 0.25% and provide forward guidance that the policy rate is expected to remain at that level, conditional on underlying inflation remaining on a projected path back to the 2% target by the end of 2017.
Let's get one thing straight: 2015 was a lousy year for Canadian investors.
A stay-at-home 60/40 investor who invested 60% of their funds in a Canadian stock ETF (XIU), 30% in a Canadian bond ETF (XBB), and 10% in a Canadian real return bond ETF (XRB) had a total return (including reinvested dividend and interest payments) of -3% in Canadian dollars. And the Canadian dollar weakened 16% against the US dollar, so in US dollar terms the all Canadian 60/40 Portfolio had a total return of about -19%.
The focus of this blog is on generating good returns by taking reasonable risk in easily accessible global (including Canadian) ETFs. To assist in this endeavour, we track various portfolios made up of a combination of Canadian and global ETFs. This allows us to monitor how the performance of the ETFs and the movement of foreign exchange rates affects the total returns and the volatility of portfolios.
Since we began monitoring these portfolios at the beginning of 2012, we have found that the Global ETF portfolios have all vastly outperformed a simple stay-at-home portfolio. As you will see in this post, that gap widened significantly in 2015.
Global Market ETFs: Performance for 2015
In 2015, with the USD and JPY both appreciating a stunning 19% and the EUR appreciating 7% against the CAD, the best global ETF returns for Canadian investors were in Japanese and US equities and USD-denominated government bonds. The worst returns were in commodities and Canadian equities. The chart below shows 2015 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 2015. In USD terms, only 4 of the 19 ETFs we track posted positive returns, while 15 ETFs posted losses for the year. In CAD terms, 16 of 19 ETFs posted gains, while just 3 posted losses.
The best gains were in the Japanese equity ETF (JPY) which returned a stunning 29.9% in CAD. The US Long (10-20 yr) Treasury Bond ETF (TLH) was second best, returning 20.6%, followed by the S&P500 ETF (SPY), which returned 20.4% in CAD. Other big gainers included USD-denominated Emerging Market bonds (EMB) 20.2%; US inflation-linked bonds (TIP) 16.9%; US Investment Grade Bonds (LQD) 16.5%; Eurozone equities (FEZ), 14.2%; US small cap stocks (IWM) 13.6%; and US high yield bonds (HYG) 13.0%. Canadian ETFs with positive returns included Canadian Long Bonds (XLB) 3.8% in CAD terms; Canadian real return bonds (XRB) 3.0%; and Canadian corporate bonds (XCB) 2.1%.
The worst performer, by far, was the commodity ETF (GSG), which returned -34.1% in USD and -21.6% in CAD. Second worst was the Canadian equity ETF (XIU) which returned -7.8% in CAD terms (including dividends), followed by the emerging market equity ETF (EEM), which returned -0.3% in CAD terms.
Global ETF Portfolio Performance for 2014
In 2015, the Global ETF portfolios tracked in this blog posted solid returns in CAD terms when USD currency exposure was left unhedged, but negative returns when USD exposure was hedged. In a November 2014 post we explained why we prefer to leave USD currency exposure unhedged in our ETF portfolios.
A simple Canada only 60% equity/40% Bond Portfolio returned -3.0%, as mentioned at the top of this post. Among the global ETF portfolios that we track, the Global 60% Equity/40% Bond ETF Portfolio (including both Canadian and global equity and bond ETFs) returned 9.2% in CAD terms when USD exposure was left unhedged, but -0.3% if the USD exposure was hedged. A less volatile portfolio for cautious investors, the Global 45/25/30, comprised of 45% global equities, 25% government and corporate bonds and 30% cash, gained 8.1% if unhedged, but -1.2% if USD hedged.
Risk balanced portfolios outperformed in 2015 if unhedged, but underperformed if hedged. A Global Levered Risk Balanced (RB) Portfolio, which uses leverage to balance the expected risk contribution from the Global Market ETFs, gained a robust 14.1% in CAD terms if USD-unhedged, but had the biggest loss of -4.4% if USD-hedged. An Unlevered Global Risk Balanced (RB) Portfolio, which has less exposure to government bonds, inflation-linked bonds and commodities but more exposure to corporate credit, returned 10.3% if USD-unhedged, but -3.4% if USD-hedged.
While the returns on our global ETF portfolios greatly outperformed the all Canadian portfolio, we should not pat ourselves on the back too much. It is worth remembering that in USD terms, all of these portfolios had negative returns. Nevertheless, if the objective was capital appreciation in CAD terms and capital preservation in USD terms, these portfolios did the job.
Three Key Policy Events of 2015
In my view, there were three key policy events that left a mark on Canadian portfolio returns in 2015. The first was the Bank of Canada's decision to cut the policy rate in January. The second was the Chinese central bank's decision to devalue to Chinese Yuan in August. The third was the US Fed's decision to hike the US policy rate in December.
The impact of each of these three decisions can be seen in the chart below which tracks weekly portfolio returns since the beginning of 2012. The Bank of Canada's decision to cut the policy rate boosted all of the ETF portfolios in January, but the unhedged global ETF portfolios saw a much larger and more sustained jump in returns as major foreign currencies appreciated sharply against the Canadian dollar.
The PBoC decision to devalue CNY caused a correction in global equity markets and contributed to the Fed's decision to hold off from hiking rates in September. The Fed pause saw equity markets stabilize somewhat until December when the Fed followed through on its promised rate hike, a move which kept the Canadian dollar under downward pressure. The Global ETF Portfolios posted solid gains in 4Q15, while the Canada only ETF Portfolio added to its losses for the year.
As we enter 2016 in a continuing uncertain environment, characterized by significant global divergences in growth and central bank policies, and depressed oil and other commodity prices, remaining well diversified across asset classes, with substantial exposure to USD-denominated assets and with an ample cash position continues to be a prudent strategy.
It's now time of year to look ahead to global macro prospects for 2016. I have posted similar outlooks for the past two years (here and here) and followed up at the end of each year with an assessment of those forecasts (here and here). I will state again why I find this exercise useful. I assemble consensus views on global growth, inflation, interest rate and exchange rate outlooks not because I have faith in forecasts. I do it because the consensus view on the year ahead is presumably already built into market prices. The consensus view, as Howard Marks says, is "what 'everyone knows' and is usually unhelpful at best and wrong at worst". What will move markets in 2016 is not the current consensus forecast, but the ways in which actual economic developments diverge from that consensus.
With the foregoing caveat in mind, here, in a nutshell, is what the consensus view is telling us about 2016:
- global real GDP growth is expected to be stronger than 2015;
- global inflation is expected to be higher than in 2015;
- The Fed is expected to hike the Fed Funds rate by 50 or maybe 75 basis points and central banks in the UK and Mexico are also expected to tighten at least once;
- The Eurozone, Japan and Canada are all expected to leave their policy rates unchanged, while one 25 bp rate cut is expected in China, India, Australia and Korea;
- In the DM, 10-year government bond yields are expected to rise in all of the economies we track except Australia; In the EM, yields are expected to rise modestly in China, Korea and Mexico, but to fall in India, Russia and Brazil.
- After strengthening against all the currencies we track in 2015, the US dollar is expected to turn in a more mixed performance. USD is expected to strengthen further against EUR, AUD, CNY, KRW, INR and BRL. However, by the end of 2016, the USD is expected to be weaker against JPY, GBP, CAD, and RUB.
- After poor performances in 2015, equity strategists tell us that US and Canadian stock markets are expected to post gains of about 5.5% and 10%, respectively.
If these consensus forecasts sound familiar, thats because they are very similar to forecasts made at the end of 2013 and the end of 2014. Each year, global growth was expected to pick up, global inflation was expected to move higher, the Fed was expected to lead global tightening, bond yields were expected to rise and North American stocks were expected to rally. Both 2014 and 2015 witnessed big macro forecast misses by the consensus. These misses were characterized by weaker than expected global real GDP growth and inflation, lower than expected bond yields, greater than expected USD strength and weaker than expected stock price gains. Are we being set up for similar forecast misses in 2016 or will this be the year when the consensus is correct and things turn around?
Global Real GDP Growth Forecasts
Last year at this time, global growth was expected by the IMF to pick up to 3.8% in 2015 while global commercial bank economists expected a more modest acceleration to 3.4%. Instead, 2015 global growth is now estimated to have slowed to 3.1%.
This year, forecasters tell us once again that global growth will pick up in 2016 to 3.6% (IMF October forecast), or to 4.0% (OECD December forecast), or to 3.4% (average of global commercial bank forecasts).
2016 real GDP growth is expected to be stronger almost everywhere, but with the notable exceptions of the US and China. Economies with the largest consensus forecast growth pickup include Canada (1.9% in 2016 vs 1.2% in 2015), Mexico (3.0% vs 2.5%), Japan (1.1% vs 0.7%), India (7.8% vs 7.4%), Australia (2.6% vs 2.3%), and Eurozone (1.8% vs 1.5%).
While global growth is expected to be a bit stronger in 2016, 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, for a third consecutive year, DM economies are expected to grow at or above their trend (or potential) rate of growth, while most EM economies are expected to grow below their trend rate. In the chart below, the blue bars show the 2016 consensus growth forecast versus the OECD estimate of the trend growth rate for each economy.
In 2016, the larger DM economies are expected to grow at an above trend pace, while Canada and Australia and are expected to grow at trend. In contrast, three of the larger EM economies are expected to grow well below trend: Brazil (3.4% below trend), Russia (1.5% below trend) and China (0.4% below trend).
In the chart above, the red bars show the latest OECD composite leading indicators (CLIs) versus trend for each of the economies. As was the case a year ago, these CLIs generally support weaker 2016 growth than economists are forecasting, with a few exceptions.
In the DM economies, the leading indicators suggest that growth could surprise on the downside, especially in US, UK, Japan and Canada. In the EM economies, CLIs suggest that growth could be weaker than expected in China, India and Mexico, but stronger than expected, although still below trend, in Brazil and Russia.
Global Inflation Forecasts
Global inflation has consistently fallen short of expectations since 2013. This has occurred in spite of unprecedented efforts by central banks to fight disinflation.
A year ago, global inflation for the entire set of world economies was expected by the IMF to edge up to 3.8% by the end of 2015 from 3.7% at the end of 2014. By October 2015, the IMF had cut its year-end 2015 global inflation forecast to 3.5%. Meanwhile, a year ago, global commercial bank economists expected weighted average inflation for 12 major economies we track to move up to 2.8% in 4Q15 from 2.1% in 4Q14. These same economists now expect that weighted average inflation for these countries fell to 2.0% in 4Q15. For 2016, the global commercial bank economists forecast that weighted average inflation for the 12 countries will rise to 2.3% in 4Q16. The OECD expects an even bigger acceleration fore the 12 countries to 2.5%.
These forecasts, many of them made between early October and early-December, may already subject to downward revision. Crude oil prices ranged from $43 to $51 per barrel during the period these forecasts were made with expectations that prices would firm further heading into 2016. Instead, in the wake of the December OPEC meeting, the price has fallen to $36/bbl in late December and looks likely to remain depressed for a considerable period of time.
In most countries, inflation can be expected to remain weak. Considerable slack remains in the global economy, especially in EM economies. Wage growth remains subdued. Commodity prices are likely to remain weak. Inflation expectations are stable and soft.
Other Non-Consensus Views
Some economists, who are not part of the consensus, have a much darker view of 2016 prospects. One such economist is David Levy, of the Jerome Levy Forecasting Centre, which has a long and enviable forecasting track record.
In a recent interview with Barron's, Levy made the following highly contrarian statements:
Levy: [T]here is no way the U.S. by itself is about to keel over. The danger is not so much that we’re going to start to slide sharply, but rather that conditions overseas will become much rockier.
Barrons: Which could pull the U.S. into a recession?
Levy: Yes, and there are several reasons why. Such a scenario has never happened, certainly not in modern history. There is no postwar recession prior to which the U.S. economy was doing fine, only to get knocked down by the rest of the world. That’s one reason people don’t see the risk. But the emerging markets are not just going into a recession, they are going through a secular adjustment. .... We expect not only a global recession, but also general asset deflation, aggravated by the fact that there is no room to cut interest rates at the major central banks.... Bit by bit, the global economy is falling into recession, with the U.S. bringing up the rear. ...We expect that the Fed will reverse course later next year. In all probability, the slowly spreading global recession will intensify and ultimately engulf the entire planet. It’s at least 2 to 1 that we’ll be in a recession at the end of 2016.
Levy is not alone in warning that 2016 could fall well short of consensus forecasts. Albert Edwards at SocGen, Niall Ferguson of Harvard, Russell Napier, and Lakshman Achuthan of ECRI are also warning of the likelihood of weaker growth or recession.
I'm not suggesting that we should toss the consensus forecast in the trash and use Levy's quite plausible forecast as a base case. But I am suggesting that we should apply a hefty discount rate to the consensus and consider the risks around the benign outcome that reflects "what everybody knows".
Conclusions and Questions
2015 turned out to be a third consecutive 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 2014-15 continue? If so, the US Fed will likely be joined by the Bank of England and perhaps a few other central banks in tightening monetary policy in 2016, while the ECB, BoJ and PBoC will likely maintain their current accommodative policies or ease further. In this scenario, the US$ is likely to continue to appreciate against currencies of countries whose central banks remain accommodative. Further appreciation of the US dollar combined with below trend growth in China, Brazil and Russia will, barring a major geopolitical event, wii likely continue to weigh on commodity prices and the currencies of commodity exporting countries.
The questions one should ask about 2016 consensus forecasts are the same as we asked a year ago:
- Can the macro divergences between above-trend growth in some key DM economies and below-trend growth in key EM economies be sustained without serious financial instability in some countries and significant volatility in global currency and financial markets?
- Can commodity prices stabilize and recover even as the USD continues to rally and global commodity supply continues to outpace global demand.
- Can China and other EM economies prevent hard landings for their over-leveraged economies?
- Can Canada and Australia, with overheated housing markets, rebound to grow at or above trend after a sharp fall in commodity prices and as the Fed continues to raise its policy rate?
- Will we look back on 2016 as yet another year that started with optimistic forecasts and ended with disappointment?
A year ago, my answers to these questions were: No, No, Don't Know, Unlikely, and Probably. I can see little reason to change these answers as we head into 2016. In the near future, I will turn to the question of how Canadian investors should think about 2016 as another year with macro risks skewed to the downside.
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.
It is time to review how the macro consensus forecasts for 2015 that were made a year ago fared. It's not only interesting to look back at the notable global macro misses and the biggest forecast errors of the past year, it also helps us to understand 2015 investment returns.
Real GDP
Since the Great Financial Crisis (GFC), forecasters have tended to be over-optimistic in their real GDP forecasts. That was true again in 2015. In the twelve major economies tracked in this blog, real GDP growth fell short of forecasters' expectations in ten and exceeded expectations in just two economies. The weighted average forecast error for 2015 was -0.46 percentage points, almost twice as large as the 2014 error.
Based on current estimates, 2015 real GDP growth for the US and fell short of the December 2014 consensus by 0.5 pct pts. The biggest downside misses were for Brazil (-4.6 pct pts), Russia (-2.7), Canada (-1.2), Korea (-1.1), Australia (-0.8), and Mexico (-0.8%). India beat forecasts by 1.1 pct pts. On balance, it was a fifth consecutive year of global growth trailing expectations.
CPI Inflation
Inflation forecasts for 2015 were seriously too high. Ten of the twelve economies are on track for significantly lower than forecast inflation, while inflation will be higher than expected in two countries. The weighted average forecast error for the 12 countries was a massive 1.7 pct pts.
The biggest downside misses on inflation were in China (-3.6 pct pts), Korea (-2.7), Mexico (-2.5%), India (-2.4), the UK (-2.3), the US (-1.9%) and Japan (-1.9%). The biggest upside misses on inflation were in countries that experienced large currency depreciations, including Russia (+5.8) and Brazil (+3.3).
Policy Rates
Economists forecasts of central bank policy rates for the end of 2015 anticipated too much tightening by DM central banks and too little easing for most EM central banks.
In the DM, the Fed, the Bank of England failed to tighten as much as expected. The Reserve Bank of Australia and the Bank of Canada, which were also expected to tighten, unexpectedly cut their policy rates. In the EM, the picture was more mixed. In China and India, where inflation fell more than expected, the central banks eased more aggressively than expected. In Russia and Brazil, where inflation was much higher than expected, Russia's central bank eased less than expected and Brazil's central bank was forced to tighten much more than expected.
10-year Bond Yields
In nine of the twelve economies, 10-year bond yield forecasts made one year ago were too high. Weaker than expected growth and inflation in most countries pulled 10-year yields down almost everywhere compared with forecasts of rising yields made a year ago.
In all of the DM economies we track, 10-year bond yields surprised strategists to the downside. The weighted average DM forecast error was -0.54 percentage points. The biggest misses were in Canada (-1.01 pct. pt.), the UK (-0.90) and the US (-0.85). In the EM, bond yields were lower than forecast where inflation fell in China, Korea and Mexico, but much higher than expected where inflation rose sharply in Brazil and Russia.
Exchange Rates
The strength of the US dollar once again surprised forecasters. 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 8.1% more than forecast a year ago.
The USD was expected to strengthen because many forecasters believed the Fed would begin to tighten around mid-2015. While the Fed had been promising to tighten this year, it found various reasons to delay, with the first tightening finally occurring on December 16. If everything else had been as expected, the Fed's delay would have tended to weaken the USD. But everything else was far from as expected. Most other central banks eased policy by more than expected. In addition, oil and other commodity prices weakened more than expected so that commodity currencies like RUB, MXN, CAD and AUD weakened much more than forecast.
The biggest FX forecast miss was, not surprisingly, the RUB, more than 30 percentage points weaker than forecast a year ago. Other big misses were for BRL (-28.2 pct pts), MXN (-21.1), CAD (-20.2) and AUD (-16.7). JPY was the only currency that depreciated less than forecast versus the USD.
North American Stock Markets
A year ago, equity strategists were cautiously optimistic that North American stock markets would turn in a solid, if unspectacular, performance in 2015. However, in a year when the major global macro surprises were weaker than expected real GDP growth and much lower than expected inflation reflecting sharp declines in commodity prices, equity performance failed to live up to forecasts. I could only compile consensus equity market forecasts for the US and Canada. News outlets gather such year end forecasts from the high profile US strategists and Canadian bank-owned dealers. As shown below, those forecasts called for a 7.5% gain in the S&P500 and a 6.2% rise in the S&PTSX Composite.
As of December 18, 2015, the S&P500 was down 3.9% (not including dividends) for an error of -11.4 percentage points. The S&PTSX300, battered by the drop in oil and other commodity prices, was down 11.0% for an error of -17.2 percentage points.
Globally, actual stock market performance was mixed on a year-to-date basis as of December 18, 2015. Stocks performed relatively well in the Eurozone and Japan, where quantitative easing continued and monetary policy became even more accommodative. China and Korea also saw gains, although both markets are well off the double digit gains seen prior to China's August equity market rout. The US and UK, where central banks tilted toward tightening monetary policy, posted losses. Brazil, Canada, Australia and Russia suffered losses inflicted by the drop in commodity prices.
Investment Implications
While the 2015 global macro forecast misses were similar in direction and larger in magnitude relative to those of 2014, the investment implications were somewhat different. Global nominal GDP growth was once again much weaker than expected, reflecting downside forecast errors on both global real GDP growth and global inflation. In 2014, this negative development for equities was more than offset by easier than expected global monetary policy, as US and other DM equity markets performed well. In 2015, most global central banks either tightened less than expected or eased more than expected, but with the Fed signalling tightening for most of the year, weaker nominal GDP growth and the strong US dollar held the US equity market to a modest decline. In Japan and the Eurozone, where central banks continued to ease, equities outperformed. In Canada, Australia, Mexico and Russia, falling commodity prices put downward pressure on equity markets.
Similar to 2014, the downside misses on growth and inflation and the central banks easing in most countries resulted in a modest positive returns on DM government bonds in 2015, and significant outperformance of 10-year government bonds versus equities in the US, UK and Canada.
Divergences in growth, inflation and central bank responses, along with the sharp declines in crude oil and other commodity prices, again led to much larger currency depreciations versus the USD than forecast. For Canadian investors, this meant that investments in both equities and government bonds denominated in US dollars, Japanese Yen and UK Sterling, leaving the currency exposure unhedged, were winners. Big losers were Canadian and EM equities, commodities, and EM bonds denominated in local currencies.
As 2016 economic and financial market forecasts are rolled out, it is worth reflecting that such forecasts form a very uncertain basis for year-ahead investment strategies. The best performing portfolios for Canadian investors in recent years have tended to be those that are well diversified, risk-balanced and currency unhedged.
At the risk of sounding like a broken record, I am going to write again about whether Canada is, was or will be experiencing a recession.
You may wonder why I am doing this. After all, on December 1 the authoritative Peter Mansbridge, anchor of the CBC National news pronounced that the recession is "officially over", citing the report from Statistics Canada that real GDP grew 0.6% (or 2.3% at an annual rate) in 3Q15 after contracting modestly in the previous two quarters. According to this interpretation, the so-called "technical recession" meaning two (or more) consecutive quarters of negative real GDP growth, a definition widely adopted by the general media and the business press, was over.
However, I have recently joined the C.D. Howe Institute's Business Cycle Committee (BCC), which is described on the Institute's web site as "an arbiter of business cycle dates in Canada.... The Council performs a similar function to the National Bureau of Economic Research (NBER) Business Cycle Dating Committee in the United States."
This is a big responsibility and one that I take very seriously. When I told my wife about it, she was puzzled, and asked why I would want to spend my time on such an activity. She correctly pointed out that most people are more interested in what will happen in the future than in having precise dates upon which the economy entered into and exited from recessions. I explained that economists can do a better job giving guidance about the future direction of the economy if they understand the causes and dynamics of past business cycles.
I was not a member of the BCC when it issued its latest report, which concluded that "as of July 22, data did not provide evidence that Canada had entered an economic downturn", but said it would review its position later in 2015.
What is a Recession?
In a background Commentary to the first report of the Business Council Committee, Philip Cross and Phillipe Bergevin defined a recession as follows:
A recession is the phase of the business cycle when aggregate economic activity is contracting.... The drop in economic activity is a self-reinforcing process, where lower incomes lead to cuts in spending, which trigger declines in output and possibly employment, which lead to further reductions in incomes.
The Commentary goes on to cite the NBER definition of recession:
A significant decline in activity spread across the economy, lasting more than a few months, visible in industrial production, employment, real income, and wholesale-retail trade.
What these definitions have in common is that they require a "significant" contraction of economic activity, measured in four key dimensions: real output, employment, real income, and real spending or sales. To qualify as "significant", a contraction must meet the 3 P's test: it must be pronounced, pervasive, and persistent. To be pronounced, the contraction must show some depth or amplitude. To be pervasive, it must demonstrate some duration or length. To be persistent, it must show scope or breadth across the key dimensions of output, employment, real income and spending.
Cross and Bergevin note that there is an element of professional judgement in dating recessions:
Although one can use these considerations as guides in identifying and dating recessions, it is worth emphasizing that it is impractical to establish preset conditions with respect to amplitude, duration, and scope because these considerations need to be judged simultaneously and because the economy and its measurement change over time. Thus, the [business cycle] chronology we present ... is the result of a careful balancing of these different considerations.
It should be clear from this discussion that Peter Mansbridge and other media commentators were not referring to any rigorous definition of recession when they pronounced that the recession is "officially over". Indeed, it may not yet be possible to determine whether a recession "officially began" sometime in the first half of 2015, because professional judgement has not yet been made on whether it was pronounced, pervasive and persistent enough to qualify as a recession.
Toward a Made-in-Canada Definition of Recession
In the excellent work on dating recessions back to 1926 done so far by the C.D. Howe Institute's Business Cycle Council, I have one fundamental problem. Of the four key dimensions of economic activity that are key to dating a recession, the BCC has only analyzed two: real output and employment.
The reason for this seems to be that Canada lacks monthly data on real sales and real income. In the United States, the NBER does not give any significant weight to quarterly real GDP in dating recessions. It relies on monthly data for industrial production, non-farm business payrolls, real personal income, and real manufacturing and trade sales.
In Canada, we have monthly data on real GDP for both the private and public sectors and monthly data on employment by industry. Statistics Canada does not produce monthly data for real income or for real sales.
This raises two questions for me.
First, are we attempting the measure and date the "business cycle" or some broader measure of the "economic cycle" comprising both the private business sector and the public sector?
It is well known that the business sector is more cyclical than the broad economy which includes the public sector. I believe that it is the business sector that is most prone to cyclical dynamics and that this should be the focus of dating business cycles rather than the total economy. That means we should focus on measures of private sector output and employment, not measures of total real GDP and total employment. Thus, it would be possible to have a business cycle recession without experiencing a significant decline in total real output or employment.
Second, in the absence of monthly data for real income, should we not include a focus on quarterly real income measures, which Statistics Canada does produce? The quarterly national income and expenditure accounts provides both measures of output, real gross domestic product (GDP) and real gross domestic income (GDI). Using measures of real income from the quarterly national accounts allows us to move toward a "made-in-Canada" definition of the business cycle.
Canada's economy is different from the US economy. Canada is a smaller, more trade dependent and more resource dependent economy than is the United States. This means that Canada's prosperity is more dependent on movements in the terms of trade (the price of its exports relative to its imports) and the exchange rate. The effects of these movements can introduce quite different behaviour in real GDI than in real GDP. As I have argued in a previous post, looking only at real output, measured by real GDP, often misses the point, especially when there are large movements in the terms of trade and the exchange rate, as has been the case in 2014-15.
A brilliant exposition of this thinking is contained in a Statistics Canada publication which I just recently stumbled upon. The 2012 study, "Natural Resources, the Terms of Trade, and Real Income Growth in Canada: 1870 to 2010", by John R. Baldwin and Ryan Macdonald, provides a rich account of the historical development of Canada's natural resources. In addition, using annual data, it measures the contributions to real income growth arising from real output growth, terms of trade shifts and exchange rate movements. It demonstrated that over the 140 year period, real income grew substantially more than real output because over that long period of time, terms of trade and real exchange rate effects added to real income growth.
Recent changes to the presentation of the quarterly national income and expenditure accounts make the same information available on a quarterly basis back to 1981. It seems feasible that such quarterly data could be calculated at least back to 1946.
The chart below shows drawdowns from quarterly peaks in real GDP and real GDI since 1981. The drawdown is the cumulative % decline from the previous peak level.
In recent recessions, in 2000-01 and 2008-09, notice that the cumulative declines in real GDI were both larger and more protracted than the declines in real GDP. This is because, the price of commodities produced in Canada fell quite sharply and the terms of trade weakened significantly. In the most recent period, real GDP fell only modestly, by just a cumulative 0.24% over the first and second quarters of 2015, but real GDI, fell for the three consecutive quarters to 3Q15 and by a much larger 1.5%. Since the terms of trade are continuing to decline in 4Q15, this story is still unfolding and it is possible that the downturn in real GDI could deepen further.
I believe that this evidence tips the scales in favour of judging that the 2015 downturn meets the 3 P's test:
- it is pronounced, particularly in the depth of decline of real GDI;
- it is pervasive, in that monthly real GDP, monthly real manufacturing and trade sales, and quarterly real GDI all experienced declines, only employment did not (so far); and
- it is persistent, in that quarterly GDI declined for three consecutive quarters, monthly GDP declined for six of the nine months months from January through September and remained well below the December 2014 peak level.
For this reason, I believe that, based on current evidence, a recession probably did begin in early 2015. I also think that it was a more serious recession than indicated by the decline in real GDP. However, I do not believe that a definitive conclusion can yet be reached on dating the beginning and the end of the recession. Unfortunately, this nuanced conclusion is unlikely to ever be reported by Peter Mansbridge on The National.
With just two weeks left in an overly-long federal election campaign. Political leaders, economists and editorialists opine on a daily basis on the nature of the ills facing the Canadian economy and their chosen policy antidotes. Exaggerated claims about how minor policy changes will reinvigorate the Canadian economy and boost the wellbeing of the "middle class" are commonplace.
Canada recorded two consecutive quarters of modest declines real GDP in the first half of 2015. This added fuel to an inane "debate" over whether Canada is in a recession. In July, Bank of Canada Governor Stephen Poloz said this about the recession debate:
I just find the discussion quite unhelpful. It's especially unhelpful when what has happened to the economy is very narrowly defined.
Poloz said the discussion was "especially unhelpful" because the contraction was narrowly focussed on the oil and gas industry and suggested that "the fundamentals are positive and gathering pace in about 80% of the economy".
While I agree that the debate about recession is unhelpful, it for different reasons.
Canada is not experiencing a normal business cycle recession. It is experiencing a severe negative terms of trade shock.
The terms of trade refers to the price of Canada's exports relative to the price of our imports. A negative terms of trade shock occurs when a country's export prices fall relative to the prices of its imports. The terms of trade is of crucial importance to Canada, a medium sized economy that depends heavily on international trade for its growth and prosperity. In Canada's case, the terms of trade are subject to large swings. This is because a large proportion of our exports are commodity based -- oil and gas, metals and minerals, forest products and agricultural products -- and the prices of these commodities are more volatile than the prices of Canada's imports, which are predominantly finished manufacturing products -- motor vehicles, consumer goods and business machinery and equipment. In recent years, oil and gas exports have become increasingly important, accounting for 23% of Canada's goods exports in 1Q 2014, before the recent sharp decline in the price of crude oil. In total, commodity-based exports accounted for 51% of Canada's total exports.
The plunge in the world price of oil, along with weakness in prices of other commodities has dealt a severe blow to Canada's terms of trade. The chart below shows the strong link between the value (in current dollar terms) of Canada's commodity-based exports and the Bank of Canada's Commodity Price Index. Indeed, the link appears to have become even closer over the past 15 years as the development of Canada's oil sands added to its commodity exports.
The latest available data show that the Commodity Price Index was down 40% in 3Q15 from a year earlier. This implies a further significant decline in Canada's commodity-based export values, which were already down 13% from a year earlier in 2Q15.
While it is well understood that falling commodity prices hurt the value of Canada's commodity-related exports, what is less well understood is the direct effect that this has on Canada's Real Gross Domestic Income (GDI). Real GDI is total domestically-generated income, adjusted for inflation, of all sectors of the Canadian economy, including the household sector, the corporate sector and the government sector.
The chart below shows the tight relationship between the value of Canada's commodity-based exports and real GDI for the total economy.
Real GDI fell 1% from a year earlier in 2Q15. Based on the further decline in commodity prices in 3Q15 and the consequent likely further decline in commodity-based export values, real GDI growth is likely to have fallen further in 3Q15, even if real GDP growth turns positive. The only times that real GDI has fallen as sharply over the past four decades are during the 1981-82 recession, the 1991 recession, the bursting of the Tech Bubble in 2001, and the Great Recession of 2008-09.
Canada's prosperity is determined, not by real GDP which is a measure of the how much we produce, or by employment which is a measure of how many of us are working and how many hours we work, but by real GDI, a measure of the real value of the income we receive for the work that we do. The prices that we receive in world markets for the commodities that we extract, process and export are a primary determinant of real GDI growth. A terms of trade shock generated by a sharp fall in commodity prices can have just as negative an impact on Canada's prosperity as a deep business cycle recession, defined by sustained declines in production and employment.
What is also little understood is that a fall in the value of the Canadian dollar which accompanies a fall in commodity prices further erodes real GDI. As the currency weakens, the prices of imported goods, which are dominated by finished consumer goods and business machinery and equipment, rise in Canadian dollar terms. This exacerbates the drop in the terms of trade and increases downward pressure on real GDI.
This is also why BoC Governor Poloz's suggestion that the effects of the terms of trade shock are "narrowly defined" is misleading. When the price of oil and other commodities declines, the real income of oil producers in Alberta falls, but so does the purchasing power of consumers in Ontario, Quebec and other provinces, who must pay more for imported goods, services and foreign travel. The terms of trade shock is shared and spread across regions and industries by the fall in the value of the Canadian dollar. The real incomes of all Canadians suffer when the price of oil plunges and the Canadian dollar depreciates in value.
The problem for politicians and policymakers is that the negative terms of trade shock comes from outside Canada, not from changes in the behaviour of domestic consumers, corporations or governments. The current terms of trade shock has many causes, including the development of new technologies that have lowered the cost of producing oil; the decision by Saudi Arabia and other OPEC countries to continue to pump oil at a high rate rather than cut production to support the oil price; and the slowdown in China's economy which has lowered demand and prices for a broad range of commodities.
Whether or not the downturn in the global commodity super-cycle causes a business-cycle recession measured by GDP and employment is not the most important issue. The most important point to grasp is that Canada is facing a period in which the combined real income of households, corporations and governments are declining and are unlikely to rebound quickly. Even if real GDP resumes growing in the second half of 2015 and employment continues to rise, we will be producing and working more but receiving less real income for our efforts.
What the Economic Debate Should be About
The real economic issue that politicians should be facing is not whether Canada has slipped into a modest business cycle recession, but rather what is the appropriate economic policy response to a lasting negative shock to our national income caused by the fall in the prices of the commodities that we produce.
The Conservative Party wants to stay the course, keeping taxes low, encouraging home-ownership, and pursuing a balanced budget. That is a reasonable start, but does not go far enough in providing incentives to boost growth outside the resource industries.
The Liberal Party wants to raise taxes on high income earners including high-income small business owners, reshuffle child benefits to favour the "middle class", and incur deficits to fund infrastructure projects. The difficulty in this approach will be to maintain business confidence and to control deficit spending in an environment of weak GDI growth.
The New Democratic Party (NDP) wants to raise corporate taxes, impose carbon taxes, expand government's role in child care, and pursue a balanced budget. This is a difficult if not impossible set of promises to deliver on during a period of weak commodity prices.
The worst election outcome, but perhaps the most likely according to current polls, would be a coalition government of the NDP and Liberals. Coalition economic policies would likely result in higher taxes on high income earners, small businesses and corporations, increased spending on government provided child-care and infrastructure, and an early loss of control of budget deficits.
All three political parties and all Canadian voters would be well advised start thinking about what kind of pro-investment, pro-growth policies Canada needs to pursue in a period when the main economic engine and source of national prosperity has stalled and shifted into reverse.
