Big Deficits, Bigger Debt: Who Cares?

Canadian governments are leaking out the bad fiscal news that comes along with slow growth and a collapse in commodity prices. The Government of Canada revealed that even before implementing the bulk of the Liberal government's spending promises made in the recent election, its projected fiscal deficit for 2016-17 has jumped to C$18.4 billion. Oil-rich Alberta's recently elected New Democratic Party Government has let slip that its projected deficit will rise to a record $10.4 billion. Newfoundland's recently elected Liberal Government has murmured that its deficit will rise to an unprecedented $2 billion (about 6% of provincial GDP).

As the bad fiscal news trickles out, many prominent Canadian economists are arguing that more fiscal stimulus is needed. Some say that a $30 billion federal deficit would be appropriate, some say $40 billion, some even say $50 billion.

They argue that Canada is in the enviable position, after almost 20 years of working down its federal government deficit and debt, of having plenty of room to add fiscal stimulus to boost an economy experiencing sluggish growth.

Personally, I don't think that allowing fiscal automatic stabilizers to push up budget deficits is a bad thing. But I do think that urging governments to increase deficits by 2 or 3 percentage points of GDP for several years carries far more risk than these economists are letting on.

Canada's Total Debt

While Canada's federal government has done a very good job of getting its' fiscal house in order over the past 20 years, Canada's total debt levels have increased dramatically over the same period. 

In 1995, Canada faced a government debt crisis. The combined gross debt of all levels of government reached 91% of GDP, with the federal government debt at 55% of GDP and other levels of government adding another 36%. At that time, Canada's total debt to GDP was 231%.

In 2015, Canada's total debt has reached 312% of GDP. While federal debt has fallen from 55% to 34%, the debt levels of all other sectors have increased significantly. Over that period, household debt has risen from 63% to 95% of GDP; non-financial corporate debt has risen from 58% to 72% of GDP; financial sector debt has risen from 19% to 69% and debt of other levels of government has risen from 36% to 42%.

Saying that Canada's federal government has plenty of room to borrow to add fiscal stimulus ignores the sharply increased debt levels of every other sector of the economy. Just looking at the government sector, it doesn't appear that the situation in 2015 is much better than it was in 1995.

Total government debt at the end of 2015 was 76% of GDP, up 24 percentage points from the recent low of 52% in 2007.  Over the past 55 years, only during Canada's government debt crisis period, which began in 1991, did total government debt exceed the level it reached in 2015. 

How Does Canada's Debt Compare?

The world is awash in debt. How does Canada compare with other countries? In 2015, the McKinsey Global Institute published a revealing study titled Debt and (not much) deleveraging. The chart below shows, on the left, McKinsey's breakdown of total debt to GDP in 2Q14 for the global economy, USA, Germany, China and Canada; and, on the right, Statistics Canada's breakdown for Canada in 2Q14 and the most recent data for 3Q15.

The comparison shows that in the McKinsey study, Canada's total debt to GDP, at 247%, was significantly higher than the global average but slightly lower than Germany (258%), USA (267%), and China (269%). Statistics Canada data, from the National Balance Sheet Accounts, shows Canada's total debt to GDP was somewhat higher in 2Q14 than the McKinsey estimate, at 287%, mainly because of a higher estimate for the debt level of financial corporations. StatCan's measure of Canada's total debt to GDP for 2Q14 is higher than the McKinsey estimates for the USA, Germany or China, in large part because of the high level of household debt. StatCan's most up-to-date estimate shows Canada's total debt to GDP has surged to 312% in 2015, reflecting increases across all sectors, but with the biggest jump in the non-financial corporate sector. A good part of the increase in corporate debt was to fund expansion in the energy and other commodity sectors of the economy when commodity prices were high.

Those economists who are encouraging the federal government to undertake stimulus to push the federal deficit up to $30 billion, $40 billion, or $50 billion are saying that the government has plenty of room to run bigger deficits. When the additional $20-30 billion deficits of the provincial governments are added, total government deficits could reach 3% to 4% of GDP over the next few years. This would push Canada's total government debt to GDP back above 80%, the level that marked the beginning of the government debt crisis of 1995. And it would come at a time when Canada's total debt to GDP was nearing 320%, compared with 230% in 1995.

Debt and Growth

A 2011 Bank for International Settlements (BIS) paper, titled The real effects of debt, summarized their research as follows,

At moderate levels, debt improves welfare and enhances growth. But high levels can be damaging. When does debt go from good to bad? We address this question using a new dataset that includes the level of government, non-financial corporate and household debt in 18 OECD countries from 1980 to 2010. Our results support the view that, beyond a certain level, debt is a drag on growth. For government debt, the threshold is around 85% of GDP. The immediate implication is that countries with high debt must act quickly and decisively to address their fiscal problems. The longer-term lesson is that, to build the fiscal buffer required to address extraordinary events, governments should keep debt well below the estimated thresholds. Our examination of other types of debt yields similar conclusions. When corporate debt goes beyond 90% of GDP, it becomes a drag on growth. And for household debt, we report a threshold around 85% of GDP, although the impact is very imprecisely estimated.

In the detail of the research, the authors report, "we see that public debt has a consistently significant negative impact on future growth. And, the impact is big: a 10 percentage point increase in the ratio of public debt to GDP is associated with a 17–18 basis point reduction in subsequent average annual growth [over the next 5 years]". In Canada's case, this suggests that the 24 percentage point rise in total government debt since 2007 could already be responsible for slowing real GDP growth by almost 0.5% per year. And the sharp rise in household and corporate debt is likely acting as a further drag on growth. 

Kenneth Rogoff and Stephanie Lo argue in in their 2014 BIS paper, that their leading candidate for the sluggish growth in the period since the financial crisis is the overhang of debt across all sectors of the economy. They argue that "these debt burdens need to be analysed in an integrative manner in order to assess the extent of an economy’s vulnerability to crisis or, in the case of advanced economies, the impact of higher debt on potential growth". They cite research that suggests "the impact of debt on growth in any given sector – whether it is government, household, or corporate – is worsened when other sectors also hold high debt. Therefore, an economy’s overall debt level and composition matter, both because private defaults can create contingent liabilities for the government and because there can be amplification mechanisms across sectors that exacerbate the negative effect of debt on growth. (For example, if private sector defaults lead to weaker growth, this affects the sustainability of government debt; if households are suffering debt problems, this can lower demand and can lead to strains in corporate debt)".

Another 2014 report, Deleveraging? What Deleveraging?, by Luigi Buttiglione, Philip R. Lane, Lucrezia Reichlin and Vincent Reinhart, surveys the inexorable rise in global debt to GDP across all sectors and concludes,

We observe a poisonous combination – globally and in almost any one geographic area – between high and higher debt/ GDP and slow and slowing (both nominal and real) GDP growth, which stems from a two-way causality between leverage and GDP: on the one hand, slowing potential growth and falling inflation make it harder for policies to engineer a fall in the debt-to-GDP ratio, and on the other hand attempts to delever both the private sector (especially banks) and the public sector (through austerity measures) encounter headwinds, as they slow, if not compress, the denominator of the ratio (GDP).

Conclusions

After the G20 meeting in Shanghai last week, Canada's new Finance Minister Bill Morneau said, "I received very positive feedback on Canada’s new path for long-term growth"... and added that the March 22 budget “will demonstrate Canada’s commitment to making smart and necessary investments in order to grow the economy." However, the Financial Times reported that G20 finance ministers clashed over the wisdom of additional fiscal stimulus. The FT quoted Wolfgang Schäuble, German finance minister, as saying from the sidelines the Shanghai meeting, "The debt-financed growth model has reached its limits. We therefore do not agree with a G20 fiscal package as some argue … There are no short-cuts that aren’t reforms."  

While many prominent Canadian economists have supported larger deficits, they do not seem to have considered the impact of bigger deficits on Canada's total debt to GDP and the consequences of record high total debt levels for medium and longer term growth. This is a particularly important at a time when Canada is facing the largest, most rapid and potential longest lasting deterioration in its terms of trade in decades -- itself a serious blow to Canada's GDP and it's capacity to support its' high level of total debt. 

In my opinion, this is an environment in which great caution is required in the formation of fiscal policy. In particular, fiscal measures that contribute to a lasting increase in structural budget deficits at either the federal or provincial level should be avoided. Government deficits will rise; automatic stabilizers should be allowed to work; some infrastructure spending that supports private sector growth should be undertaken, temporary tax incentives to encourage private sector investment could also have a positive short-term effect without increasing structural deficits. But large increases in federal and provincial government budget deficits -- at a time when the debt of other levels of government and the private sector are at record highs -- would pose a significant threat to Canada's longer-term economic growth and stability.

The Bond Market is Talking: Is the Bank of Canada Listening?

Don't get me wrong. I am not complaining that the Bank of Canada didn't take my advice last month to cut the policy rate. It was a close call. Many Bay Street analysts were frightened that a rate cut could trigger a currency crisis. The national media was focussed on the impact of a weaker Canadian dollar was having in pushing up imported food prices and the cost of Florida vacations. 

The January decision fell on the same day that rookie Prime Minister Justin Trudeau was making his maiden appearance at the  Davos World Economic Forum, telling the world that he wanted Canadians to be known "for our resourcefulness" rather than for our resources. Cutting the policy rate on the same day might have been a disconsonant signal for the Bank of Canada to send when Trudeau was assuring the world that "Canada has something else that isn’t so easily quantifiable. Confidence".

I have been very supportive of the BoC's actions since they began cutting the policy rate in January 2015. The Bank responded in a timely and appropriate fashion to the plunge in Canada's terms of trade that began in the summer of 2014, cutting the policy rate in two 25 basis point steps in January and July to it's current level of 0.50%. I recommended a further cut in January because commodity prices and Canada's terms of trade had continued to fall sharply. Prior to the decision,  I noted that "if the BoC decides not to cut rates the Canadian dollar will likely rally, preventing it from acting as the cushion to the terms of trade drop that it needs to be". That is exactly what has happened.

In the January 20 press conference that followed the Bank of Canada decision to leave the policy rate unchanged, Governor Stephen Poloz listed three considerations that led the Bank not to act on its "bias toward further monetary easing". These included:

• Information on the size, type and timing of federal fiscal stimulus was not yet available. The BoC preferred to wait until the Federal Budget is tabled to get a fix on how fiscal stimulus might accelerate the return to full capacity in the economy, which the BoC estimated would be "late 2017 and perhaps later", a "significant setback" from it's October projection.
• Depreciation of the Canadian dollar since October 2015 would add considerably more stimulus to the non-resource sectors of the economy than previously projected, although it could take up to two years for this effect to be fully felt.
• A further rapid depreciation of the Canadian dollar "could push overall inflation higher relatively quickly. Even if this is temporary, it might influence inflation expectations."

In the Q&A portion of the press conference, Poloz elaborated on the risk that inflation expectations could rise if the the C$ fell rapidly and pushed up prices of imported goods. However, he stated:

"We don't think that's happening. We believe inflation expectations are very well anchored on 2% after 25 years of successful inflation targeting. But that is a consideration that we need to bear in mind when the exchange rate is moving quickly".

Later in the Q&A, Poloz noted that how the Bank reacts to Canadian dollar weakness in the future would depend on the context. If the C$ were falling for no apparent reason, that would be a concern. But, he noted, "If the oil price is going down some more, that's another negative for the Canadian economy, and so the dollar is doing part of the adjusting for us".

The BoC Monetary Policy Report suggested that another possible rationale for not cutting the policy rate was "highly stimulative" financial conditions, adding that "reductions in the Bank’s policy interest rate in January and July 2015 contributed importantly to these accommodative financial conditions".

The Bond Market is Talking...

One of the best ways to assess the effect of monetary policy actions (or inaction) is to look at how the bond market responds. We can look at the spread between nominal and inflation-linked bonds as an indicator of inflation expectations. We can look at movements in the yield curve as an indication of the markets real GDP growth expectations. And we can look at credit spreads as an indicator of financial conditions.

The chart below shows Canada's breakeven inflation rate as measured by the spread between the yield on nominal long term Government of Canada bonds and the yield on the Canada Real Return Bond (RRB). The breakeven inflation rate is a market-based measure of expected inflation.

While Governor Poloz cited a risk of a rise of inflation expectations, the bond market is saying that the real risk is that inflation expectations could become unanchored from the 2% target on the downside. The latest market based estimate of inflation expectations, the breakeven rate, has fallen steadily since the summer of 2014 to just 1.29% on February 11. The BoC responded to downward moves in inflation expectations with two rate cuts in 2015, but has not yet responded to the further decline in 2016.

The next chart shows the Canadian yield curve, measured by the spread between the Government of Canada 10-year bond and the 2-year bond. A higher spread, i.e. a steeper yield curve, is a market based indicator of stronger expected real GDP growth. A flatter curve indicates expectations of weaker growth ahead.

Governor Poloz was upbeat on growth prospects, anticipating that actual GDP growth will exceed potential growth in 2016 and 2017, causing the economy to return to full capacity. But the yield curve has flattened significantly since the beginning of 2016, suggesting that market participants are anticipating slower growth ahead. The bond market is expecting a larger dose of fiscal stimulus in the 2016 federal budget than the new Liberal Government promised during the election campaign, but still expects growth to slow further.

A third message from the bond market is that financial conditions are tightening despite the monetary easing supplied by the BoC in 2015. The chart below shows the spread between investment grade corporate bonds and the Government of Canada bonds of similar duration. 

Source: Barclays

The corporate spread has widened since the summer of 2014 by almost 90 basis points and is wider than at any time over the last decade with the exception of the credit crisis of 2008-09. Wider spreads reflect higher risk premia on corporate debt and tighter financial conditions for business. Further evidence of tighter credit conditions is provided by Bank of Canada data on the effective borrowing rate on business loans, shown in the chart below.

The interesting aspect of this chart is that, while the effective borrowing rate fell when the BoC cut the policy rate in January 2015, it actually rose after the second rate cut to 3.12% by early February, virtually unchanged from where it was before the BoC began cutting the policy rate.

In summary, the bond market is telling quite a different story from the one used by the BoC to justify remaining on hold on January 20. The market, via the breakeven inflation rate, is saying that the risk to inflation expectations is that they may be becoming unanchored from the 2% target on the downside, not the upside, with market-based long term inflation expectations falling to just 1.3%.  Through the yield curve, the bond market is saying that expected real GDP growth is falling, not rising, in spite of expected greater fiscal stimulus. Through the corporate credit spread, the market is saying that financial conditions are tightening, not easing, and have reached levels not seen outside the credit crisis of 2008-09. 

... Is the Bank of Canada Listening?

Since the BoC decided not to move on January 20, much has transpired. 

• Crude oil prices, which opened the year at US$37 per barrel, have fallen below US$30/bbl, or by another 20%.
• Amidst financial market turmoil, other global central banks have eased policy further, either by moving to more deeply negative policy rates (ECB, BoJ, Sweden's Riksbank) or by tempering policy rate guidance (US Fed).
• The Canadian dollar has rallied as other central banks have eased their monetary policy stances, trading today about 5% higher than just before the Bank of Canada decided to leave the policy rate at 0.50%.

The decision by the BoC to stand pat contributed to the appreciation of the Canadian dollar while the oil price and the terms of trade have weakened further, inflation expectations have taken another sharp step down, the yield curve has flattened indicating weaker expected real GDP growth, and the corporate spread has widened pointing to tighter financial conditions.

To be fair, the BoC could not have been expected to anticipate these recent developments. But these developments point out the potential costs of waiting for the federal budget, which is unlikely to bring any major surprises for the markets. The BoC would likely have preferred not to have to deal with a further drop in oil prices, financial market turmoil, and shifting foreign central bank policies. However, they are now a part of the macro environment that the BoC must take into account as it decides whether to stand pat again on March 9.

Momentum Shift

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.   

  

The Bank of Canada Should Stay on Course

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.  

Global ETF Portfolios: 2015 Returns for Canadian Investors

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.

2016 Economic Outlook: Consensus and Other Views

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. 

Global Macro Misses: Biggest Forecast Errors of 2015

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.